Subir Gokarn: Striking the balance between growth and inflation in India
Presentation by Dr Subir Gokarn, Deputy Governor of the Reserve Bank of India, at the
USIndia Economic and Financial Partnership: CII and Brookings Institution, Washington DC,
27 June 2011.
* * *
Inputs from Bhupal Singh, Ashish George and G.V. Nadhanael are gratefully acknowledged.
I. Introduction
The Indian economy recovered relatively quickly from the financial crisis of 2008, but
inflationary pressures emerged even in the early stages of the recovery in late 2009. Over
the past year and a half, the challenge for monetary policy has been to contain these
inflationary pressures without disrupting the recovery. The economy grew by 8.5 per cent in
the fiscal year 2010-11, which is close to the five-year average pre-crisis, but year-end
headline inflation was over 9 per cent, well above tolerance limits. Meanwhile, global
developments have implications for both growth and inflation trajectories in India over the
coming months. In this presentation, I propose to talk about the key global and domestic
factors that are shaping our growth and inflation outlook, as a backdrop to discussing
monetary policy actions and their impact. I will then briefly talk about challenges to
communication.
II. Global forces
There are widespread perceptions and increasing concerns about the recovery in the
advanced economies losing momentum. High energy prices appear to be feeding into a
negative cycle of persistent unemployment and depressed housing prices in the US and UK,
while the prospect of sovereign default and its real and financial consequences dominates
the European policy discussion. In contrast, emerging Market Economies (EMEs) are
showing symptoms of demand-driven inflationary pressures, which have, over the past
several months, been exacerbated by rising global commodity prices. Apart from all the other
things that are going on in the global environment, commodity prices have played a key role
in India's inflation over this period. Consequently, their likely trajectory is going to be an
important factor in influencing India's inflation path.
Charts 1 and Chart 2 provide some perspective on this. They display the correlations
between the build-up of non-commercial long positions in four commodities - crude oil,
copper, cotton and soya beans - and price movements. It appears that that trading positions,
possibly driven by abundant liquidity, are contributing to recent price escalations, except in
cotton, where temporary supply disruptions have been the main factor. Significantly, in recent
weeks, there has been a reversal in long positions, which in turn is associated with softening
of prices. If this trend persists, it will provide substantial relief for global inflation
management, particularly for large commodity importers, including India. Further, although
hardly a desirable way to control inflation, slowing global growth, in addition to reinforcing
these favourable commodity price trends, will also help to moderate demand and keep
capacity utilization low. This will contribute to moderating inflationary pressures coming from
traded or tradable goods.
III. Domestic growth prospects
2010-11 was a year in which the economy continued its recovery from the impact of the
financial crisis. Growth bottomed out at 6.8 per cent in 2008-09, the crisis year, picked up to
8 per cent in 2009-10 and further to 8.5 per cent in 2010-11. Chart 3 shows two pictures of
the growth trajectory. With reference to aggregate and sectoral Gross Domestic Product
(GDP) estimates, the trajectory in the graph suggests that the momentum is moderating
somewhat, as the most recent quarters show decelerating year-on-year growth rates. The
main contributor to this tendency is the industrial sector, which has shown relatively high
volatility over the period displayed. It slowed significantly during the crisis, recovered sharply
subsequently and has recently begun to slow down.
Looking at the industrial sector a little more closely, the graph displaying trends in industrial
production provide some clues to its dynamics. The most volatile segments of the index, both
of which are displayed on the graph, are capital goods and consumer durables. These are
generally seen as being the most interest-sensitive components of the index and their recent
trends suggest that the impact of contractionary monetary policy is having an impact. Along
with softening commodity prices, this trend will contribute to bringing inflation under control,
by helping moderate demand pressures. Of course, industry associations, including
Confederation of Indian Industry (CII), have been consistent critics of the monetary policy
stance, arguing that it is slowing growth without really impacting inflation, which is being
driven by supply side pressures. I will address this critique both in the discussion on inflation
and the one on communication.
In short, the domestic growth scenario suggests that the growth rate will moderate somewhat
in the coming year. The Reserve Bank of India projects growth during 2011-12 to be
8 per cent in its baseline scenario. From the inflation management perspective, this is not an
entirely undesirable outcome. If it results in a significant reduction in the inflation rate, it will
represent a soft landing, which in turn opens up the opportunity for a reversal in the interest
rate cycle. However, many unknowns stand in the way and ultimately, inflation outcomes will
determine the monetary stance.
IV. Domestic inflation dynamics
Over the past year, the nature of inflation has changed in significant ways. Chart 4 provides a
broad picture of the dynamics. Headline inflation began to accelerate in the second half of
2009-10, at a time when growth was still relatively sluggish. It stayed high through 2010-11,
actually accelerating in the last quarter of the year. In the first two months of 2011-12, that
pattern has persisted. However, the relative importance of the drivers of inflation clearly
changed over the period displayed. Food inflation was the predominant contributor in the
early phase, but a resurgence of energy prices in the post-crisis environment began to play
an increasingly important role. The prices of non-food manufactured products, which the RBI
views as a reflection of demand pressures, began to rise noticeably in early 2010, but saw
their rate of increase stabilize and even moderate somewhat in the third quarter of 2010-11.
However, that pattern was short-lived and the rate of inflation for this category surged in the
fourth quarter, a momentum that has clearly persisted into the current year.
The changing contributions of different drivers are very sharply brought out in the
decomposition exercise displayed in Chart 5. The analysis looked at recent patterns in terms
of three periods of roughly equal lengths over the past 14 months, beginning April 2010. In
the first period, food and energy, reflecting classic supply-side forces, were the primary
contributors to inflation. Non-food manufacturing inflation, which, to the extent that it
represents demand pressures, was not insignificant, suggesting that pricing power was
present. In the second period, the weight of the contribution shifted dramatically towards
commodities other than energy. The contribution from food moderated a bit, as did that from
non-food manufacturing, suggesting that the pass-through or "generalization" risk was
moderating. However, this pattern was short-lived. In the last period, energy returned as a
major contributor and the sharp increase in the contribution of non-food manufacturing
indicated that producers were able to pass on higher input costs without too much difficulty.
The strength of the pass-through in this period indicated that demand conditions remained
quite robust, even as some early signs of moderation were coming through the production
estimates and feedback from industry.
I want to put particular emphasis on food price dynamics, as I believe that this is likely to be a
significant factor in the medium term. Although the overall contribution of food to inflation
moderated over the past year, there are structural demand-supply imbalances at work, which
will keep the pressure up in the absence of large and sustainable increases in supply. This
phenomenon is demonstrated in the graph in Chart 6. The main point that the graph makes
is that the prices of protein sources have deviated sharply from their trend in recent years
and show no signs of reverting to it. By contrast, the prices of other foods have also shown
periodic deviations from trend, but have generally reverted. This pattern has, of course
contributed to high volatility, as the Chart also demonstrates.
Volatility in food prices does have a welfare-reducing impact, but in the current Indian
context, the much greater concern is the long-term nutritional impact of elevated protein
prices. At a time when the combined impact of demographic transition and income increases
is generating enormous demand for proteins, the supply chain is clearly struggling to meet
this demand.
To conclude this part of the discussion, let me bring in the issue of inflationary expectations.
The persistence and recent acceleration of inflation has clearly increased the risk of
expectations becoming unanchored. The RBI monitors short-term expectations through
household surveys. Recent surveys have reinforced the perception that household
expectations are moving up. Food prices play an important role in this process, but whatever
the causes, the impact on wage-setting in both explicit and implicit contracts cannot be
dismissed. However, the relative stability of long-term (10-year) yields on government
securities suggest that expectations over this horizon remain anchored. This is reinforced by
our regular surveys of professional forecasters, which also indicate no loss of confidence in a
moderate inflation scenario over the medium and long run.
V. Monetary policy: actions and transmission
The current cycle of contractionary monetary policy was initiated in the context of two
important factors. First, there was an enormous volume of liquidity in the domestic financial
system, as a result of policy responses to the crisis, which also took policy rates to very low
levels. Second, even as the early signs of recovery were visible, inflationary tendencies had
also begun to show. All this was happening in a global environment which was still quite
turbulent and uncertain in late 2009 and early 2010. Chart 7 shows the trajectory of policy
instruments - the Repo, the Reverse Repo and the Cash Reserve Ratio (CRR) in the
precrisis, crisis and recovery periods.
In contrast to the very sharp and quick actions on rates and liquidity that were taken in
responding to the crisis, the recovery has been characterized by a much more calibrated
approach. This was motivated by considerations related to the factors that I mentioned
earlier. A more aggressive response to the incipient inflationary pressures may have been
warranted under somewhat more predictable domestic growth and global scenarios, but in
both these respects the situation in early 2010 was nowhere near stable or predictable. A
calibrated approach, which was essentially a relatively frequent series of small rate hikes,
was seen as the best way to balance the potentially conflicting objectives.
In the early phase of the cycle, surplus liquidity conditions persisted, which, clearly made
transmission of policy rates through to transaction rates very sluggish. From this perspective,
the early actions were essentially a signaling effort, accompanied by steady moves to
eliminate the liquidity surplus through CRR increases. By the middle of the 2010, the liquidity
scenario had moved to a deficit and transmission became much stronger. Chart 8 shows the
immediate impact on the call rate, which is effectively the operating target of monetary policy,
of a change in the liquidity situation. The strengthening of transmission was visible across a
variety of financial market segments. Charts 9 and Chart 10 provide some illustrative
evidence of this.
In Chart 9, the call and Collateralized Borrowing and Lending Operations (CBLO) rates, a
secured short-term channel of liquidity management, are shown with reference to the
reporeverse repo corridor. The transmission intensity is quite clear, with the added dimension of
movement from the lower bound of the corridor to the upper bound, as liquidity conditions
tightened. Chart 10 shows the yield on 10-year government securities and that on 5-year
AAA corporate bonds from the same perspective. Transmission is visible here as well.
Of course, the banking system is by far the more important intermediary in the Indian
financial context and what banks do matters a great deal. Significantly, a similar analysis of
transmission through bank lending rates does not suggest that it is as strong as that in
markets. Chart 11 displays the dynamics of bank lending rates in response to policy rate
changes in both the expansionary and contractionary cycles. The sensitivities do not appear
to be very strong. Rates did not come down very sharply in the expansionary phase and,
while they are increasing in the contractionary phase, the magnitudes appear to be small.
Aggregation problems may be masking some of the impact. In the RBI's consultations with
industry, the fact that banks are aggressively passing on rate increases is often alluded to,
which is undoubtedly intended as a complaint, but is entirely consistent with monetary policy
objectives.
Finally, in the context of monetary actions and transmission, let me address the issue of real
rates. One consistent critique of the monetary stance, that it has been behind the curve, is
based on the criterion that real rates have been and still are negative. Of course, this leads to
a usually inconclusive debate on what the deflator should be, but widespread perceptions
that real rates are negative are likely to impact both spending behaviour and expectations.
This then leads to the more operational issue of whether rates are to be brought into positive
territory relatively rapidly or gradually.
Charts 12 and Charts 13 provide some perspective on the real rate issue. As Chart 12
shows, with the recent acceleration in inflation, many real rates, measured in the simplest
way of subtracting either current headline inflation or core inflation from the nominal rate, are
negative when the headline rate is used to deflate. The picture changes, but hardly
decisively, if the core (non-food manufacturing) inflation is used. So, going by some of these
indicators, it may appear that the policy stance is not contractionary enough. However, when
we look at some other measures of real rates, specifically bank lending rates as depicted in
Chart 13, the picture is a little different. Allowing for differences in risk and other
differentiating prices, real rates are significantly positive. As I said, this is a criterion on which
the debate in the Indian context is yet unresolved and is keeping some of my colleagues in
the research departments engaged. The point I would like to make is that, at least in terms of
a large proportion of financial transactions, real rates are positive. It remains a matter of
judgment whether they are lower than they should be and, if so, how quickly the necessary
adjustment should be made.
This judgment is partly related to the issue of expectations. Looking back over the past year
and a half, the balancing act between growth and inflation can also be seen in a slightly
different way. There is also a tradeoff between minimizing the sacrifice of growth and not
letting expectations run out of control as a result of inflation persistence, exacerbated by new
shocks.
In the run-up to its recent Annual Policy statement, the RBI made an assessment that this
had indeed emerged as a risk. Against a backdrop of firm and possibly rising commodity
prices, the prospects of inflation going down soon were seen as not being very high. This
supported the decision to send a stronger signal of commitment to bringing inflation under
control. However, in our baseline projections, the cumulative impact of the tightening that has
been done over the past few quarters - the call rate has moved up by about 450 basis points
over a little more than a year - is likely to soften both growth and inflation in the second half
of 2011-12. If this trajectory materialized as anticipated, the monetary stance could then
respond accordingly. But, ultimately, as I indicated earlier, the stance is going to be
predominantly determined by the actual and prospective inflation outcomes.
VI. Issues of communication
This is an enormous challenge at the best of times, which becomes even more complex in
circumstances like the current ones. Let me briefly address two sets of issues, to which a lot
of thought is being given.
First, there is the concern with forecasts going wrong. Having been an analyst in my previous
position, I am quite used to making frequent changes in forecasts, as new information
emerges. The difference in this position is that actual decisions, with huge national
consequences have to be made on the basis of forecasts that might be very short-lived. This
poses risks to credibility, because actions consistent with one forecast may not be equally so
with the revised one. Apart from improvements in forecasting methodology, which is really a
long-term process, there are immediate implications of this problem. One is to make better
and more explicit assessments of alternative scenarios and then make policy decisions, taking
into account the risks associated with different scenarios materializing. In effect, this is being
done, but perhaps the communication strategy around it perhaps needs to be fine-tuned.
Second, there is the issue of communicating the goals of monetary policy. For a variety of
reasons, we have chosen not to commit to a formal and explicit inflation target, which has
many advocates in the country. There is a credibility risk to not being held accountable to a
single target, but there is also a risk to regularly missing that target, even if it is due to factors
outside the control of monetary policy. But, that does not mean that some clear and, most
importantly, achievable, goals should not be articulated. We attempt to do this with every
policy statement and look very carefully at feedback and public comments and debate that
appear to have read messages different from what we intended and how we can sharpen it.
In this connection, the growth-inflation trade-off and sometimes conflicting perceptions of it is
a significant issue. Going by theory and empirics, the trade-off is essentially a short-term
one, with monetary policy aiming to keep growth at close to its long-term, structural trend as
possible. Contractionary policy will slow growth down only to the extent that the economy is
growing beyond its capacity, provoking inflation. It cannot, in terms of this framework, have
any significant impact on the trend rate of growth. In fact, long-term growth can only be
helped, not hurt, by low and stable inflation. However, much of the debate tends to view any
slowdown in growth resulting from an anti-inflationary monetary stance as a long-term
sacrifice, i.e., a downshift in trend. We need to articulate the distinctions involved more
strongly, which has been done rather consciously in recent statements, but again perhaps
needs to be sharpened.
VII. Concluding remarks
The inflationary situation is India's most significant near-term macroeconomic challenge.
There are some factors, global and domestic, that are clearly outside the purview of
monetary influence. But, that doesn't mean that monetary policy does not have a role in
addressing factors that it does influence - demand pressures and the risks of inflation
becoming generalized through expectations and price-setting actions. To the extent that
growth may be impacted, it must be understood as a short-term tradeoff, with positive
consequences for long-term performance. Finally, the contribution of supply forces, which I
have highlighted with the example of proteins, but which also exert pressure elsewhere, can
only be addressed by increasing supply. Measures to do this are an integral part of a
longterm inflation management strategy.
I would like to thank CII and the Brookings Institution for inviting me to speak at this seminar
and look forward to listening to the comments of the panelists and the participants.
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