Subir Gokarn: Managing the growth-inflation balance in India - current
considerations and long-term perspectives
Keynote address by Dr Subir Gokarn, Deputy Governor of the Reserve Bank of India, at the
Private Equity International India Forum, Mumbai, 5 October 2010.
* * *
The inputs of Sitikantha Pattanaik, Bhupal Singh and Sangita Misra in preparation of this address are gratefully
acknowledged.
Introduction
I would like to thank the Private Equity International India Forum for inviting me to deliver this
Keynote Address. I believe that channels of finance like venture capital will play an
increasingly significant role in India. Sustaining the current growth momentum over a long
period of time will clearly depend heavily on the ability of new business ideas to first, find
start-up funding and then, grow to scales at which traditional funding sources can be
accessed. Historically, this role was played in the Indian economy by the Development
Finance Institutions. In the current and future scenario, the function has shifted to companies
like the ones represented at this forum, whose business model depends on successful
navigation of the start-up to listing phase of the businesses that they finance. In turn, the
likelihood of success depends on a stable and predictable macroeconomic environment.
The long-term growth prospects of the Indian economy provide an enormously attractive
investment environment for a range of businesses and, consequently, for the people who
would finance them. However, as attractive as the opportunity may seem, the assessment
would not be complete without a full understanding of the risks. In my address this morning, I
will focus on the risk of macroeconomic instability, with particular emphasis on the issue of
inflation: what drives it and whether it threatens to get out of control. An unavoidable
consequence of runaway inflation, however we define it, is that drastic action by the central
bank and also by the government is needed to rein it in, which is bound to disrupt the growth
process. The challenge, therefore, is to keep inflation in check over long periods of time,
allowing the economy to grow at its potential rate with minimal disruptions and deviations.
This is the best way in which the macroeconomic environment can contribute to a positive
business climate.
I will begin by discussing the current inflationary scenario in India, which, as we have been
saying in our recent assessments, is not very reassuring. I will then place this scenario in a
broad historical context, with the intention of demonstrating that India has a good record of
reining inflation in, regardless of what has driven it. The structure of the domestic economy
and the financial system may have changed and the global context may be different, but the
effectiveness of inflation control over the decades has not diminished.
The current scenario
As you well know, the predominant policy concern in the Indian economy as recently as one
year ago was the significant slowdown in growth in the wake of the financial crisis in the
advanced economies. As Slide 1 shows, the inflation rate, which was briefly negative in the
middle of 2009, began to accelerate rapidly later in the year. This upward momentum
continued into the first half of 2010, with double-digit inflation persisting for a few months.
The rapidity of the transition was surprising, given the fact that the recovery in growth was
just getting under way and, importantly, the global situation was still very uncertain. However,
as Slides 2 and 3 indicate, the reason for the sharp increase was that all the possible drivers
of inflation were simultaneously contributing. Each one by itself may not have resulted in the
outcome that we saw, but all three working together resulted in a rather sharp acceleration.
Slide 2 displays the pattern of supply-side pressures, as manifested in the food and fuel
components of the Wholesale Price Index. Food prices rose sharply because the monsoon of
2009 was deficient in most parts of the country, impacting agricultural production. However,
there are, I believe, longer term forces at work on food prices, which are a matter of concern.
I shall address these later on in the speech. Fuel prices also rose as the prospects of a
global recovery improved and, particularly, the Emerging Market Economies actually saw a
sharp acceleration in growth.
However, what was most significant from the monetary policy perspective was the growing
visibility of demand-side pressures. Slide 3 tracks the price dynamics of the manufacturing
sector - overall and without the food processing component. The latter has been used by
many analysts as a reasonable proxy of demand-side inflation, which is the phenomenon
that monetary policy can and should influence. Both graphs in the slide and, particularly the
one displaying non-food manufacturing inflation, show a tremendous acceleration from a
significantly negative rate of inflation during 2009 to reach rather worrisome levels by the
middle of 2010.
Slide 4 compares the relative contributions of the supply and demand drivers. The graph
shows quite clearly that food and fuel prices, reflecting supply-side forces and the prices of
manufactured goods, reflecting demand-side ones, all contributed significantly to the recent
rise in inflation. If we look back a little at the inflationary surge immediately preceding the
crisis, we can see that the pattern is quite similar. This leads me to a broader point about the
drivers of inflation in India. Whenever we see worryingly high levels of inflation, both supply
and demand pressures seem to be at work.
The final point in the discussion on the current scenario is with reference to monetary policy
responses. Slide 5 shows displays the movement of the overnight call money rate, which
reflects the combined actions taken by the Reserve Bank on policy rates and liquidity. To
place the recent policy actions in perspective, we must remember that the response to the
crisis involved an enormous reduction in both policy rates and the cash reserve ratio in late
2008 and early 2009. Along with this, a number of ad hoc measures were also taken. As the
crisis abated, even if inflationary pressures had not manifested as they did, the need to exit
from the crisis management stance would have motivated some actions on rates and liquidity
- of course, at a pace that would not derail the still incipient recovery.
This process began in October 2009, with the withdrawal of most of the ad hoc measures,
but gained momentum in January 2010, with an increase in the cash reserve ratio and,
further, in March 2010 with the first of a series of rate hikes. The pace and sequencing of
actions was, as we articulated in our various assessments, determined by the need to
balance a number of potentially conflicting factors. First, we needed to address the rapidly
mounting demand-side inflationary pressures while ensuring that the recovery was not cut
short by a surge in interest rates. Second, while the domestic economy was doing well, the
global environment remained uncertain, with a number of new stress points emerging
periodically.
Third, apart from everything else, it was imperative that we normalize the monetary policy
stance from where it had moved during the crisis management phase. Not doing so would
have put us in the situation of being unable to respond to another negative shock, were it to
materialize. In sum, our policy actions over the past several months were motivated by the
twin objectives of sustaining the recovery while reining in inflation and normalizing the policy
stance as quickly as possible. In our mid-quarter assessment last month, we indicated that
the normalization process is now close to being complete and that further actions on rates
and liquidity will be driven more significantly by what the growth and inflation numbers tell us,
both domestically and globally.
Of course, the proof of the pudding is in the eating. Do we believe that our actions are having
the desired effect? On the growth front, while there is a certain amount of volatility visible in
industrial production, by and large, there is no significant indication of the recovery stalling.
On the inflation front, as was visible in the slides that I showed earlier, there are distinct signs
of a deceleration of inflation over the past couple of months. The turnaround coincides with
our expectation that inflation begins to respond to monetary actions after a six month lag. To
examine this more closely, we look at the Seasonally Adjusted Month-on-Month rates of
inflation, which give a sense of the momentum of inflation. Slide 6 displays the pattern of this
indicator. It clearly suggests that the momentum is currently negative. While the turning point
on the overall index is early in 2010, the sharp deceleration in recent months may reflect the
impact of monetary actions and gives us confidence that the inflation rate will moderate
significantly by the end of the fiscal year 2010-11.
I would like to conclude this discussion by emphasizing the point that the current episode of
inflation posed a significant challenge to policymakers by virtue of its timing. Monetary policy
responses had to be calibrated to the needs of dealing with inflation while sustaining a
growth recovery in a still uncertain global environment. The choices on the magnitude,
sequencing and timing of actions were driven by the need to find a balance between these
factors.
Long-term perspectives
Let me now take a longer term view of the growth-inflation balance in the Indian economy. To
begin with, we do have a fairly explicit statement of what we see as a desirable rate of
inflation, consistent with the economy growing at its potential rate on a sustained basis. Our
policy reviews say that we would like inflation to be in the 4-4.5 per cent range in the
medium-term, while aspiring for a 3 per cent rate in the long term. This might sound a little
unrealistic in the current scenario, but in order to both justify the aspiration itself as well as
assess its realism we need to look at the historical record of inflation management in the
Indian economy.
Slide 7 provides a very revealing picture of how the growth-inflation balance has shifted in
the Indian economy. The first graph, relating decadal averages of growth and inflation over
the past several decades clearly indicates that a steady upward movement in the growth rate
has been accompanied by a steady downward movement in the inflation rate. The contrast is
even more striking when we remove the agricultural sector, which is the slowest growing
among the three - Agriculture, Industry and Services - over long periods of time, from the
growth calculations. These patterns clearly suggest that there is no long-term trade-off
between growth and inflation; if anything, accelerating growth is accompanied by
decelerating inflation.
This may appear to be an obvious conclusion. The textbook treatment of the growth-inflation
trade-off sees it as an essentially short-run phenomenon, with the quantum of resources and
capacity in the economy being fixed. However, the reason I specifically mention this point is
that in the wake of recent assessments that the Indian economy is poised to significantly
increase its growth rate many people have asked me whether this will be accompanied by an
inflationary surge. My answer to this is precisely with reference to the distinction between the
short-run and the long-run relationship between growth and inflation. In the short-run, with
capacities fixed, a surge in growth can cause the economy to overheat, thus stoking
inflationary pressures. This is the bread-and-butter issue of monetary policy, the effectiveness
of which must be judged by its ability to keep the economy growing at a rate just short of
overheating, thereby keeping inflation in check.
In the long run, capacities are not fixed. Acceleration in growth over long periods of time
occurs in part because investment activity, which itself contributes to growth, leads to an
increase in capacity. This pushes up the potential growth rate of the economy, i.e., the rate at
which it can grow without causing overheating. Looking back over the growth performance of
the Indian economy, it is quite evident that the acceleration of growth from the 5-6 per cent
range to the 8-9 per cent range was accomplished by a massive increase in investment. As
Slide 8 indicates, the Investment-GDP ratio rose quite sharply over the decades. Even the
relatively high number of 30.5 per cent during the last decade masks the sharp surge in this
ratio towards the middle of the decade, which saw it rise above 35 per cent. At that rate of
investment, the capacity of the economy to increase output is growing quite rapidly and its
ability to meet the requirements of a growing and increasingly affluent population is clearly
expanding.
In short, the secret to accelerating growth while still being able to keep inflation in check over
long periods of time is in the speed and efficiency of the supply response. As long as the
growth in supply keeps pace or even exceeds the growth in demand, inflationary pressures
do not sustain. Supply can be expanded by enhancing domestic capacity, which the Indian
economy has clearly done, or by tapping into global sources, which the significant
liberalization in trade policy, particularly since the early 1990s, also enabled.
However, while this combination of domestic and global supply responses has helped to
steadily bring the inflation rate down, the Indian economy has always been vulnerable to
inflation shocks, which have caused uncomfortable spurts in prices across the board. Slide 9
identifies some major shocks to the system, all of which required strong policy responses. As
is evident from the graph, the vulnerability of the Indian economy to supply shocks on the
food and energy fronts is persistent. There have also been periods in which a significant
fiscal expansion accompanied by an accommodating monetary stance - i.e., demand-side
pressures - raised the inflation rate significantly. Sharp depreciation of the rupee in the midst
of an oil shock has also played a role on one occasion. While the demand driven inflation
shocks can be avoided by prudent monetary and fiscal policies, the vulnerability to supply
shocks in the form of a failed monsoon or a surge in oil prices will obviously remain.
Slides 10-12 display some of the characteristics of the transformation of the inflation
scenario in India. On Slide 10, we see how the relative contributions to inflation have
changed over the decades. Food has been a steady source of inflation over the entire period.
Energy became a significant factor during the 1970s, following the first oil shock of 1973. It
has persisted in its contribution since then. Adding up the two provides the overall
contribution of supply-side factors, which, as the graph suggests, have persisted in one form
or another through the entire period. Looking ahead, it would be reasonable to argue that
these pressures are likely to persist, as a result of both global and domestic imbalances
between demand and supply.
On the energy front, one of the fundamental drivers of high oil prices is increasing demand in
Emerging Market Economies, whose rising affluence is resulting in very rapid growth of
energy-intensive activities. As relatively low-cost reserves of fossil fuels are exhausted, rising
global demand is being met by exploiting higher cost sources. The cost differential between
petroleum and alternative sources makes such sources viable even at their relatively high
costs. Steadily rising costs of production, in turn, exert inflationary pressures on the global
economy, which hits those economies hardest whose energy intensity is increasing most
rapidly. In recent years, the prices of petroleum, as well as other commodities, are perceived
to have been further impacted by their emergence as an attractive asset class. However, as
significant as the contribution of this factor may have been to price increases, the underlying
fundamentals are what will continue to drive prices in the coming years.
As regards food, the pressures in the Indian economy are predominantly domestic. Our
Green Revolution in the 1960s raised the production of cereals dramatically, which increased
availability and stabilized prices. However, what we are seeing today is the impact of
increasing affluence on the demand for a variety of food items that go far beyond cereals. As
people become more affluent, their diets diversify. Just as the growing Indian consuming
class has stimulated a boom in the demand for consumer durables, vehicles and mobile
phones, to give but a few examples, it has also manifested an enormous increase in the
demand for various food items beyond cereals. Demand for protein sources - pulses, milk,
meat, fish and eggs - has surged as has the appetite for sugar, fruits and vegetables.
In the case of consumer durables, vehicles and mobile phones, the expansion in capacity
was enormous and rapid, resulting in the demand being met without prices increasing. In
fact, economies of scale and technological advancements actually helped to bring down the
prices of many products even as volumes were increasing. The globalization of the supply
chain also contributed significantly, as global capacities were brought into play to meet the
rising demand. This combination of forces has certainly not been in play in meeting the rising
domestic demand for the food items mentioned above. Supply is predominantly domestic
and, for the most part, is unable to respond effectively to the expansion in demand. The
inevitable consequence of this is an increase in prices. This is a significant structural driver of
inflation in the Indian economy. A good monsoon may provide some relief, while a bad one
will aggravate the pressures, but the enduring solution to this problem lies in a rapid and
sustained increase in the supply of these items.
Slide 10 also displays the positive impacts of effective supply response. The contribution of
manufactured goods to inflationary pressures has declined significantly over the decades.
This decline can be attributed to increasing effectiveness of policy reforms in increasing
domestic capacities and competition and integrating domestic markets with the global supply
chain.
In Slide 11, we look at inflation dynamics from the macroeconomic policy perspective, i.e.,
monetary and fiscal actions that may have contributed to the rise and fall of the inflation rate.
During the 1970s and 1980s, the monetization of the fiscal deficit, as reflected in the height
of the bar showing the growth in net RBI Credit to Government, was clearly a contributor to
inflationary pressures in the economy. Government spending boosts demand and if the
government faces no effective financial constraints, it can increase spending without limit
and, certainly beyond the capacity of a relatively closed economy to meet the demand.
The emergence of an effective constraint on monetization of the fiscal deficit during the
1990s helped to rein this source of inflationary pressure in. Now, if the Government wants to
increase its spending, it has to raise resources from the market, bringing in some realistic
cost-benefit calculations, including the fact that the cost of funds for the private sector will
also increase. Against this backdrop, the Government's commitment to fiscal prudence in the
form of fiscal responsibility legislation is an important contribution to maintain the
growthinflation balance.
It is also striking in Slide 11 that, contrary to popular notions about the link between the
growth in money and the inflation rate, the rate of growth of money remained constant even
as inflation declined. The reason for this was that the expansion in money was absorbed by
the growing volume of transactions that involved money exchange. This absorption mitigated
the potentially inflationary impact of money growth.
One important consideration in inflation management is the stability of the inflation rate.
Forward-looking transactions build in some expectations about inflation rates over the tenure
of the contract. Significant deviations of actual outcomes from expected ones can cause
huge losses to one of the transacting parties, thereby acting as a deterrent to what may be
growth-enhancing transactions. The more stable the inflation rate, the less these deviations
will be. There appears to be an almost universal correlation between the level of the inflation
rate and its stability. As Slide 12 shows, this relationship is quite evident in the Indian
context. The reduction in the average inflation rate over the years has been accompanied by
a sharp reduction in the volatility of that rate. The aspiration of a "low and stable" inflation
rate is a realistic one.
Finally, let me make a few comments on the role of monetary policy in this transition from a
relatively high-inflation economy to a relatively low-inflation one. Conventional monetary
policy began to apply only during the 1990s, with the freeing up of restrictions and mandatory
allocations of credit to various sectors. Genuine markets for both products and credit
emerged after the reforms of the early 1990s. As Slide 13 shows, the persistent inflationary
conditions during the 1990s were responded to by significant monetary actions in terms of
both rates and liquidity management. As the inflation rate trended lower, a process to which
the monetary policy actions of the period contributed, the policy stance in turn changed to
accommodate the new circumstances. In other words, monetary policy has been aimed at
keeping inflation under control, which involves tightening when inflation exceeds the comfort
level and loosening when it falls below.
Concluding remarks
The current inflation scenario is a cause of concern, as the inflation rate persists well above
the upper bound of the comfort zone. The fact that these inflationary pressures emerged
rather quickly in a situation in which the economy was just beginning to recover from the
significant slowdown of 2008-09 made the policy challenge more complicated. The monetary
policy response to these pressures has been a calibrated one, seeking a balance between
sustaining the recovery and reining in inflation, while being mindful of the risks that still
remain in the global environment. Recent data suggest that the approach is working, with the
economy set to grow at a reasonably healthy rate during the current year and the inflation
rate beginning to decline, including, significantly, in the manufacturing sector, where inflation
is seen as being most responsive to monetary actions.
This approach must be viewed in the context of a long-standing policy commitment to
maintain a balance between growth and inflation in the short run, while fostering faster
growth with lower inflation over long periods of time. The growth pattern of the Indian
economy over the past six decades clearly shows that accelerating growth has been
accompanied by declining inflation. This is primarily because growth has been driven by
expanding capacities across the board as well as, in recent years, by increasing global
linkages. Both these factors have helped to achieve a strong supply response to growing
demand, thus keeping inflation in check.
This is not to say that the Indian economy is now invulnerable to inflation shocks. Food and
energy price shocks have been a regular part of the economic landscape and may continue
to be so in the future. Food prices, in particular, are now being driven by some structural
imbalances between demand and supply, as increasingly affluent consumers diversify their
dietary patterns away from cereals and towards protein sources. This calls for an effort to
quickly increase the availability of these items, on which is contingent the longer term outlook
for food price inflation.
However, over the years, both fiscal and monetary policy approaches have clearly
assimilated the lessons of the past and have moved in a direction which helps contain
inflationary pressures even as growth remains robust. Making inflation low and stable was
the outcome of a combination of long-term and short-term policies over the past decades.
Keeping it there remains the objective, while an appropriate combination of long-term and
short-term policies will provide the instrument to achieve it.
I thank the organizers of this event once again for giving me this opportunity and thank you
for listening.
BIS Review 129/2010
BIS Review 129/2010
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BIS Review 129/2010
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BIS Review 129/2010
BIS Review 129/2010