COMMENT

Rajans Target: Ination or the Poor?

Ination targeting is intended to protect the poor, but it does not work that way.
Rohit writes:

eserve Bank of India (RBI) Governor Raghuram Rajan said that Parliament should set ination targets for the central bank to follow. On the face of it, this looks like the RBI is trying to hold itself accountable to the elected representatives of the people, especially where the interests of the poor are concerned. But is that really so? Targets have become the rule of the day with the Fiscal Responsibility Budgetary Management (FRBM) Act taking the lead on the scal front and now ination targeting (IT) on the monetary front. A lot has been written about the FRBM from opposite perspectives but the policy of IT in India is a more recent phenomenon. India has been witnessing signicantly high rates for ination since mid-2009 and, except for some blips here and there, ination has continued to remain quite high. This obviously hurts those whose income is not indexed to ination. There are broadly two categories of people who are hurt most by ination. One obvious group is the poor; the not-so-obvious group consists of those who have invested in nancial assets, the real value of which depreciates with ination. The way IT works is that it is assumed that there is a trade-off between ination and output; so to bring ination down one needs to reduce the level of output (thereby the level of employment too gets affected). Output can be brought down with a higher rate of interest, which would adversely affect two of the most important components of total output, private investment and credit-nanced consumption. On the face of it, this policy stance looks just ne. But there is many a slip between the cup and the lip, in particular if the underlying assumption of a trade-off between output and ination turns out to be incorrect. Output is normally assumed to be positively related to ination because the per unit cost of production is assumed to increase with output. This can happen for a variety of reasons: the strength of labour unions can grow with an increase in employment which leads to stronger wage demands; the productivity of inputs like labour can decrease with increased usage (in the jargon of economics, there is diminishing marginal productivity of labour); supply constraints on other inputs can push up their prices. So, any reduction of production is supposed to bring down the costs of these factors and, thereby, ination. But what if these reasons do not hold in a developing country like ours?

For a developing economy like India with a vast reserve army of labour (reected in a large unorganised sector), assuming a rise in the bargaining strength of the working class alongside a growth in employment seems very distant from reality. Moreover, if the usage of all inputs is rising in tandem there is no reason why an additional unit of output will cost more than the previous unit. In other words, there hardly seems to be a direct relationship between output and ination. Therefore, any policy to control ination by targeting a lower level of output will be counterproductive. It will not only not control ination it will also increase unemployment and create fears of a recession which could further fuel such pessimistic expectations. That this has been witnessed by India in the last two-three years should not come as a surprise. While the index of industrial production (IIP) has seen a declining trend in growth over the period of a continual hike in interest rates, ination has hardly abated except in the rise in prices of commodities where the monsoon has played a supportive role. This brings us to the question of why ination has been so stubborn over the past few years. The answer to this question lies in looking at the cost rather than the demand side. Kalecki, a Marxist economist, had proposed that while prices of industrial commodities are cost-determined, those of primary commodities are demanddetermined. Indeed, can one say that the prices of automobile rise just because there has been a surge in its demand? On the other hand, this can be true for agricultural commodities. So it is obvious that ination which has entered the system with the rise in prices of the latter, cannot be controlled by bringing down the production of the former. Moreover, ination because of a rise in prices of critical imported inputs like oil (because of an increase in dollar prices and/or depreciation of the rupee) also cannot be controlled by bringing down production and employment. For primary commodities, ination essentially follows from inadequate and volatile production, speculative hoarding and commodities futures. What the government needs to do then is not follow a conventional IT approach but attack the real sources of ination by (a) countercyclical taxation of oil and related items (increase tax rates when their prices in rupee terms are low and vice versa); (b) improvement and investment in storage capacities across the country; (c) controlling the futures market; and (d) cracking down on commodity hoarders.

Economic & Political Weekly

EPW

march 29, 2014

vol xlix no 13