Raghuram Rajan: The fight against inflation - a measure of our
institutional development
Text of the Foundation Day Lecture by Dr Raghuram Rajan, Governor of the Reserve Bank
of India, at Tata Institute of Fundamental Research, Mumbai, 20 June 2016.
* * *
I thank the Tata Institute of Fundamental Research for inviting me to give this Foundation
Day lecture. I have always seen TIFR with awe from afar. Some explanation is in order. My
roommate in my first year at MIT was Dr. Renganathan Iyer, who is one of the smartest
mathematicians I know - he used to help me understand my tutorials in real analysis. And he
never missed an occasion to tell me how much smarter everyone else at TIFR was. Perhaps
Renga was being modest, but I half expected on coming here today to see everyone with
gigantic heads housing enormous brains. It is a relief to find that, outwardly, you all look
normal. Seriously, however, I think the continuing success of TIFR suggests to us that when
India wants to set up world class institutions, it can. While the Institute was fortunate to have
a visionary like Dr. Homi Bhabha as its founding director, the institution has been built by the
collective efforts of dedicated researchers like you all. Congratulations on a job well done!
In my speech today, I thought I would describe our efforts to build a different kind of
institution, not one that delves into the deepest realms of outer space or into the tiniest
constituents of an atom, but one that attempts to control something that affects your daily life;
inflation. There are parallels between the institution building you have done, and what we are
setting up to control inflation, though clearly our efforts are much less tied to investigating the
very fabric of the universe and more towards influencing human behavior. Ultimately, both
require a fundamental change in mindset.
The costs of inflation
High inflation has been with us in India for the last four decades. Most recently, we have
experienced an average of more than 9 percent inflation between 2006 and 2013.
What are the costs of having high inflation? Clearly, everyone understands the costs of
hyper-inflation, when prices are rising every minute. Money is then a hot potato that no one
wants to hold, with people rushing straight from the bank to the shops to buy goods in case
their money loses value along the way. As people lose faith in money, barter of goods for
goods or services becomes the norm, making transacting significantly more difficult; How
much of a physics lecture would you have to pay a taxi driver to drive you to Bandra;
moreover would the taxi driver accept a physics lecture in payment; perhaps you would have
to lecture a student, and get the student to sing to the taxi driver...you get the point,
transacting becomes difficult as hyperinflation renders money worthless.
Hyperinflation also has redistributive effects, destroying the middle class' savings held in
bonds and deposits. The horrors of hyperinflation in Austria and Germany in the 1920s still
make scary reading.
So clearly, no one wants hyperinflation. But what if inflation were only 15 percent per year?
Haven't countries grown fast over a period of time despite high inflation? The answer is yes,
but perhaps they could have grown faster with low inflation.1 After all, the variability of
inflation increases with its level, as does the dispersion of prices from their fundamental
value in the economy. This makes price signals more confusing - is the price of my widget
going up because of high demand or because of high generalized inflation? In the former
case, I can sell more if I produce more, in the latter case I will be left with unsold inventory.
Production and investment therefore become more risky.
Moreover, high and variable inflation causes lenders to demand a higher fixed interest rate to
compensate for the risk that inflation will move around (the so-called inflation risk premium),
thus raising the cost of finance. The long term nominal (and real) interest rates savers
require rises, thus making some long-duration projects prohibitively costly.
These effects kick in only when inflation is noticeably high. So it is legitimate to ask, "At what
threshold level of inflation does it start hurting growth?" Unfortunately, this question is hard to
answer - developing countries typically have higher inflation, and developing countries also
have higher growth. So one might well find a positive correlation between inflation and
growth, though this does not mean more inflation causes more growth. For this reason, the
literature on estimating threshold effects beyond which inflation hurts growth is both vast as
well as inconclusive. Most studies find that double digit inflation is harmful for growth but are
fuzzier about where in the single digits the precise threshold lies.2
The inflation target
Nevertheless, given the limited evidence, why do most countries set their inflation goal in the
low single digits - 2 to 5 percent rather than 7 to 10 percent? Three reasons come to mind.
First, even if inflation is at a moderate level that does not hurt overall growth, the
consequences of inflation are not evenly distributed. While higher inflation might help a rich,
highly indebted, industrialist because his debt comes down relative to sales revenues, it hurts
the poor daily wage worker, whose wage is not indexed to inflation.3 Second, higher inflation
is more variable. This raises the chance of breaching any given range around the target if it
is set at a higher level. To the extent that a higher target is closer to the threshold, this makes
it more likely the country will exceed the threshold and experience lower growth. Third,
inflation could feed on itself at higher levels - the higher the target, the more chances of
entering regions where inflation spirals upwards.
The received wisdom in monetary economics today is therefore that a central bank serves
the economy and the cause of growth best by keeping inflation low and stable around the
target it is given by the government. This contrasts with the earlier prevailing view in
economics that by pumping up demand through dramatic interest rate cuts, the central bank
could generate sustained growth, albeit with some inflation. That view proved hopelessly
optimistic about the powers of the central bank.
There is indeed a short run trade-off between inflation and growth. In layman's terms, if the
central bank cuts the interest rate by 100 basis points today, and banks pass it on, then
demand will pick up and we could get stronger growth for a while, especially if economic
players are surprised. The stock market may shoot up for a few days. But you can fool all of
the people only some of the time. If the economy is producing at potential, we would quickly
see shortages and a sharp rise in inflation. People will also start expecting the central bank
to disregard inflation (that is, be hopelessly dovish according to the bird analogies that
abound) and embed high inflationary expectations into their decisions, including their
demand for higher wages. If contrary to expectations, the central bank is committed to
keeping inflation under control, it may then be forced to raise interest rates substantially to
offset that temporary growth. The boom and bust will not be good for the economy, and
average growth may be lower than if the cut had not taken place. This is why modern
economics also says there is no long run trade-off between growth and inflation - the best
way for a central bank to ensure sustainable growth is to keep demand close to potential
supply so that inflation remains moderate, and the other factors that drive growth, such as
good governance, can take center stage.4
Put differently, when people say "Inflation is low, you can now turn to stimulating growth",
they really do not understand that these are two sides of the same coin. The RBI always sets
the policy rate as low as it can, consistent with meeting its inflation objective. Indeed, the fact
that inflation is fairly close to the upper bound of our target zone today suggests we have not
been overly hawkish, and were wise to disregard advice in the past to cut more deeply. If a
critic believes interest rates are excessively high, he either has to argue the government-set
inflation target should be higher than it is today, or that the RBI is excessively pessimistic
about the path of future inflation. He cannot have it both ways, want lower inflation as well as
lower policy rates.
At the same time, the RBI does not focus on inflation to the exclusion of growth. If inflation
rises sharply, for instance, because of a sharp rise in the price of oil, it would not be sensible
for a central bank to bring inflation within its target band immediately by raising interest rates
so high as to kill all economic activity. Instead, it makes sense to bring inflation back under
control over the medium term, that is, the next two years or so, by raising rates steadily to the
point where the bank thinks it would be enough to bring inflation back within the target range.
Let me emphasize that this is not a prediction of either the path of oil prices or a forecast of
our monetary actions, lest I read in the paper tomorrow "RBI to raise rates". More generally,
the extended glide path over which we are bringing inflation in check appropriately balances
inflation and the need for reasonable growth.
Arguments against what we are doing
There are many who believe we are totally misguided in our actions. Let me focus on four
criticisms. First, we focus on the wrong index of inflation. Second, we have killed private
investment by keeping rates too high. Somewhat contradictorily, we are also hurting the
pensioner by cutting rates too sharply. Third, monetary policy has no effects on inflation
when the economy is supply constrained, so we should abandon our attempt to control it.
Fourth, the central bank has little control over inflation when government spending dominates
(what in the jargon is called "fiscal dominance").
The wrong index
Historically, the RBI targeted a variety of indicators, putting a lot of weight on the Wholesale
Price Inflation (WPI). Theoretically, reliance on WPI has two problems. First, what the
common citizen experiences is retail inflation, that is, Consumer Price Inflation (CPI). Since
monetary policy "works" by containing the public's inflation expectations and thus wage
demands, Consumer Price Inflation is what matters. Second, WPI contains a lot of traded
manufactured goods and commodity inputs in the basket, whose price is determined
internationally. A low WPI could result from low international inflation, while domestic
components of inflation such as education and healthcare services as well as retail margins
and non-traded food are inflating merrily to push up CPI. By focusing on WPI, we could be
deluded into thinking we control inflation, even though it stems largely from actions of central
banks elsewhere. In doing so we neglect CPI which is what matters to our common man, and
is more the consequence of domestic monetary policy.
The effective real interest rate, investments, and savings
Of course, one reason critics may advocate a focus on WPI is because it is low today, and
thus would mean low policy rates. This is short-sighted reasoning for when commodity prices
and global inflation picks up, WPI could well exceed CPI. There is, however, a more subtle
argument; the real interest rate is the difference between the interest rate a borrower pays
and inflation - it is the true cost of borrowing in terms of goods like widgets or dosas. If policy
interest rates are set to control CPI, they may be too high for manufacturers who see their
product prices appreciating only at the WPI rate. I am sympathetic to the argument, but I also
think the concern is overblown. Even if manufacturers do not have much pricing power
because of global competition, their commodity suppliers have even less. So a metal
producer benefits from the fall in coal and ore prices, even though they may not get as high a
realization on metal sales as in the past. The true measure of inflation for them is the inflation
in their profits, which is likely significantly greater than suggested by WPI.
A second error that is made is to attribute all components of the interest rate paid by the
borrower to monetary policy. For heavily indebted borrowers, however, a large component of
the interest rate they pay is the credit risk premium banks charge for the risk they may not
get repaid. This credit risk premium is largely independent of where the RBI sets its policy
rate.
So when someone berates us because heavily indebted industrialists borrow at 14% interest
with WPI at 0.5%, they make two important errors in saying the real interest rate is 13.5%.
First, 7.5% is the credit spread, and would not be significantly lower if we cut the policy rate
(at 6.5% today) by another 100 basis points. Second, the inflation that matters to the
industrialist is not the 0.5% at which their output prices are inflating, but the 4% at which their
profits are inflating (because costs are falling at 5% annually). The real risk free interest rate
they experience is 2.5%, a little higher than elsewhere in the world, but not the most
significant factor standing in the way of investment. Far more useful in lowering borrowing
rates is to improve lending institutions and borrower behavior to bring down the credit risk
premium, than to try and push the RBI to lower rates unduly.
The policy rate in effect plays a balancing act. As important as real borrowing rates for the
manufacturer are real deposit rates for the saver. In the last decade, savers have
experienced negative real rates over extended periods as CPI has exceeded deposit interest
rates. This means that whatever interest they get has been more than wiped out by the
erosion in their principal's purchasing power due to inflation. Savers intuitively understand
this, and had been shifting to investing in real assets like gold and real estate, and away from
financial assets like deposits. This meant that India needed to borrow from abroad to fund
investment, which led to a growing unsustainable current account deficit.
In recent years, our fight against inflation also meant the policy rate came down only when
we thought depositors could expect a reasonable positive real return on their financial
savings. This has helped increase household financial savings relative to their savings in real
assets, and helped bring down the current account deficit. At the same time, I do get a lot of
heart-rending letters from pensioners complaining about the cut in deposit rates. The truth is
they are better off now than in the past, as I tried to explain in a previous lecture, but I can
understand why they are upset when they see their interest income diminishing.
The bottom line is that in controlling inflation, monetary policy makers effectively end up
balancing the interests of both investors and savers over the business cycle. At one of my
talks, an industrialist clamored for a 4% rate on his borrowing. When I asked him if he would
deposit at that rate in a safe bank, leave alone invest in one of his risky friends, he said "No!"
Nevertheless, he insisted on our cutting rates significantly. Unfortunately, policy makers do
not have the luxury of inconsistency.
Supply constraints
Food inflation has contributed significantly to CPI inflation, but so has inflation in services like
education and healthcare. Some argue, rightly, that it is hard for RBI to directly control food
demand through monetary policy. Then they proceed, incorrectly, to say we should not
bother about controlling CPI inflation. The reality is that while it is hard for us to control food
demand, especially of essential foods, and only the government can influence food supply
through effective management, we can control demand for other, more discretionary, items in
the consumption basket through tighter monetary policy. To prevent sustained food inflation
from becoming generalized inflation through higher wage increases, we have to reduce
inflation in other items. Indeed, overall headline inflation may have stayed below 6 percent
recently even in periods of high food inflation, precisely because other components of the
CPI basket such as "clothing and footwear" are inflating more slowly.
Fiscal dominance
Finally, one reason the RBI was historically reluctant to lock itself into an inflation-focused
framework is because it feared government over-spending would make its task impossible.
The possibility of fiscal dominance, however, only means that given the inflation objective set
by the government, both the government and the RBI have a role to play. If the government
overspends, the central bank has to compensate with tighter policy to achieve the inflation
objective. So long as this is commonly understood, an inflation-focused framework means
better coordination between the government and the central bank as they go towards the
common goal of macro stability. I certainly believe that the responsible recent budget did
create room for the RBI to ease in April.
Pragmatic inflation focus
As you will understand from all that I have been saying, monetary policy under an inflation
focused framework tries to balance various interests as we bring inflation under control. In
doing so, we have to have a pragmatic rather than doctrinaire mindset. For example,
emerging markets can experience significant capital inflows that can affect exchange rate
volatility as well as financial stability. A doctrinaire mindset would adopt a hands-off
approach, while the pragmatic mindset would permit intervention to reduce volatility and
instability. Nevertheless, the pragmatic mind would also recognize that the best way to obtain
exchange rate stability is to bring inflation down to a level commensurate with global inflation.
Similarly, while financial stability considerations are not explicitly in the RBI's objectives, they
make their way in because the RBI has to keep growth in mind while controlling inflation. So
if the RBI's monetary policies are contributing to a credit or asset price bubble that could lead
to a systemic meltdown and growth collapse, the RBI will have to resort to corrective
monetary policy if macro-prudential policy alternatives are likely to prove ineffective.
The transition to low inflation
The period when a high inflation economy moves to low inflation is never an easy one. After
years of high inflation, the public's expectations of inflation have been slow to adjust
downwards. As a result, they have been less willing to adjust their interest expectations
downwards. Household financial savings are increasing rapidly as a fraction of overall
household savings, but not yet significantly as a fraction of GDP.5 Some frictions in the
interest rate setting market do not also help. Even while policy rates are down, the rates paid
by the government on small savings are significantly higher than bank deposit rates, as are
the effective rates on tax free bonds. I am glad the government has decided to link the rates
on small savings to government bond rates, but these rates will continuously have to be
examined to ensure they do not form a high floor below which banks cannot cut deposit
rates. All in all, bank lending rates have moved down, but not commensurate with policy rate
cuts.
The wrong thing to do at such times is to change course. As soon as economic policy
becomes painful, clever economists always suggest new unorthodox painless pathways.
This is not a problem specific to emerging markets, but becomes especially acute since
every emerging market thinks it is unique, and the laws of economics operate differently
here. In India, at least we have been consistent. Flipping through a book of cartoons by that
great economist, RK Laxman, I found one that indicated the solution for every ill in 1997
when the cartoon was published, as now, is for the RBI to cut interest rates by a hundred
basis points. Arguments change, but clever solutions do not.
Decades of studying macroeconomic policy tells me to be very wary of economists who say
you can have it all if only you try something out of the box. Argentina, Brazil, and Venezuela
tried unorthodox policies with depressingly orthodox consequences. Rather than experiment
with macro-policy, which brings macro risks that our unprotected poor can ill afford, better to
be unorthodox on microeconomic policy such as those that define the business and banking
environment. Not only do we have less chance of doing damage if we go wrong, but
innovative policy may open new paths around old bottlenecks. Specifically, on its part the
RBI has been adopting more liberal attitudes towards bank licensing, towards financial
inclusion, and towards payment technologies and institutions in order to foster growth.
Institution building
Let me return to institution building. We had gotten used to decades of moderate to high
inflation, with industrialists and governments paying negative real interest rates and the
burden of the hidden inflation tax falling on the middle class saver and the poor. What is
happening today is truly revolutionary - we are abandoning the ways of the past that
benefited the few at the expense of the many. As we move towards embedding institutions
that result in sustained low inflation and positive real interest rates, this requires all
constituencies to make adjustments. For example, if industrialists want significantly lower
rates, they have to support efforts to improve loan recovery so that banks and bond markets
feel comfortable with low credit spreads. The central and state governments have to continue
on the path of fiscal consolidation so that they borrow less and thus spend less on interest
payments. Households will have to adjust to lower nominal rates, but must recognize that
higher real rates make their savings more productive. They will find it worthwhile to save
more to finance the enormous investment needs of the country.
Adjustment is difficult and painful in the short run. We must not get diverted as we build the
institutions necessary to secure a low inflation future, especially because we seem to be
making headway. The Government has taken the momentous step of both setting a CPI
based inflation objective for the RBI as well as a framework for setting up an independent
monetary policy committee. In the days ahead, a new governor, as well as the members of
the committee will be picked. I am sure they will internalize the frameworks and institutions
that have been set up, and should produce a low inflation future for India.
The rewards will be many. Our currency has been stable as investors have gained
confidence in our monetary policy goals, and this stability will only improve as we meet our
inflation goals. Foreign capital inflows will be more reliable and increase in the longer
maturity buckets, including in rupee investments. This will expand the pool of capital
available for our banks and corporations. The government will be able to borrow at low rates,
and will be able to extend the maturity of its debt. The poor will not suffer disproportionately
due to bouts of sharp inflation, and the middle class will not see its savings eroded. All this
awaits us as we stay the course. Thank you very much for your patience in listening to me.
References
Bruno Michael and William Easterly. 1995. "Inflation Crises and Long-Run Growth," NBER
Working Paper No. 5209 (Cambridge, Massachusetts: National Bureau of Economic
Research).
Easterly William and Stanley Fischer. 2001. "Inflation and the Poor." Journal of Money, Credit
and Banking. Volume 33, Issue 2. May. 160-178
Fischer Stanley 1993. "The Role of Macroeconomic Factors in Growth". Journal of Monetary
Economics. Volume 32, Issue 3, December 1993, Pages 485-512
Khan, Mohsin S., and Abdelhak S. Senhadji. 2000. "Threshold Effects in the Relationship
Between Inflation and Growth," IMF Working Paper 00/110 (Washington: International
Monetary Fund).