Inflation is a PIG; but so is rupee value

What is PIG? In non-capital letters, of course we can define the animal – whether quadruped or human. But nowadays a new set of inflation measures are also known as PIG - Pure Inflation Gauges, as explained by two renowned economists, Dr Krishna Durba and Dr Urjit Patel.

Most of India's financial newspapers seem to believe that interest rates and inflation are inversely linked, and that you can slay the inflation dragon with the interest rate sword.

I am not too sure.

Over the period 2010-2013, the Reserve Bank of India effected over 13 policy rate hikes, but the Wholesale Price Index today is still rising at 6 per cent; the Consumer Price Index is in double digits; and food inflation at 18 per cent.

And mind you, rupee twerking in a manner not seen even by Miley Cyrus (10 per cent movement either way in just a few days!).

Clearly something is out of sync. Maybe inflation is no more just a monetary phenomenon, any more than monsoons are a rain event. And interest rate and inflation best share a correlation between the two, but that should not be confused for causation.

There are three issues which need attention:
What to target? a) Inflation (CPI, WPI, Core, etc); b) GDP; or c) external economy (rupee, current account deficit).

Which policy instruments and methods to tag each target with? And what should these targets be?

While the Reserve Bank has been looking at WPI, it is actually CPI which impacts the public. That is the inflation index it should target. If one goes by the PIG theory that food and energy does not contribute to inflation, then choosing between headline or core inflation is meaningless. Whatever is the appropriate target is par for the course.

What inflation does is hose the feedback loop on negative sentiments. Businesses and firms are holding off on investments and projects, consumers are looking to alternate non productive assets. Credit offtake is low, and with little or no impact on output, prices and employment and the economy is in a tailspin of its own making. So while inflation targeting is necessary, focus on it solely as a panacea for economic ills is misshapen.

Let me put it this way. India is an economy which is 50 per cent underground, where proper estimates of money supply and impacts of tightening and loosening is not known or measurable (think System D in France). India is still a 96 per cent cash economy with 12 trillion crores of M0 circulating in the economy, and just 50 per cent of all non-cash measurable split evenly between cheque and electronic channels.

This formal economy cannot be a good approximate of the informal one. And therein lies the problem. A case in point is that even with a good monsoon and good agricultural output, prices of agricultural products are high, and imports are being resorted to. It would seem demand and supply forces are not working themselves through the system, and information is asymmetric on account of supply chain inefficiencies and distributional distortions.

Growth is the critical factor – without it, we are seeing high inflation and unemployment. Better to have growth with inflation and employment.

The rupee should be allowed to find its own level as it is a barometer of how the world economy views the strength of the Indian economy. Intervention by the RBI should be swift and determined if the rupee is under speculative stress. Not dictating the rate, but preventing volatility. Not by resorting to textbook tools but beating the speculators whether they be dealers, brokers, traders, arbitragers  from within an institutional system or working within the dark anonymous shifting shoals of international finance.

The problems of the rupee are not fundamental but on account of shorting and profit-taking by the gnomes of Zurich.

The trade deficit or CAD is more addressable, and gold imports should be controlled rather than cutting off external remittances. On parallel, increasing the supply of dollars is important through foreign direct investment (FDI), share purchase by parent companies, exports, invisibles and de-risking on pure FII inflow is paramount.

There are schools of thought where some are of the view that you need one policy instrument for one objective. Central banks have a toolkit for each policy instrument - for example, the repo rate, MSC, CRR, SLR, reverse Repo, etc.

Sometimes, one signals a course of action with one instrument only to send the opposite signal with the other tools at ones disposal. Even if you don't use more than one instrument to tackle one goal – one must have congruence.

A more critical issue is inflation targets - whether inflation should be 200 basis points behind growth, and growth set at 7.5- 8.5 per cent. This is what some economist call as NGDP targeting. In the USA the trilemma is a three way drift between inflation, GDP and unemployment – and in trying to find the sweat spot. In India it is just two - inflation and growth. Of course the third could be the fiscal deficit or even CAD. But just to keep things simple I have take these as the two main macroeconomic objectives on a merit order basis.

Currently, with growth down, it is important to bake a larger cake. Inflation may be a concomitant. But it cannot be the determinant. Therefore some amount of inflation has to be tolerated and perhaps even encouraged for risk: return perceptions to play a role in freeing up animal spirits of enterprise and industry.