RBI should hike rates now to fight inflation: NIPFP

Ajay Shah, senior fellow, NIPFP believes that the central bank should now raise interest rates to fight soaring inflation. "I would have been horrified if there had been a rate cut. I personally think that it is time to raise rates. It is time to fight inflation," he said in an interview to CNBC-TV18.

He feels that the way monetary policy is being handled is the reason behind India's inflation woes. "Inflation is finally and in the long term always a monetary phenomenon. We have been above the 5% upper threshold of CPI inflation in every single month from February 2006 onwards. This is not a short, quick, temporary burst of inflation. This is deeper monetary policy problem."

Below is the edited transcript of Shah’s interview with CNBC-TV18. Also watch the accompanying videos.

Q: First up your comment on the Reserve Bank action or lack of it, lack of an expected rate cut on June 18th that has been you advice isn’t it?

A: No. I would have been horrified if there had been a rate cut. I personally think that it is time to raise rates. It is time to fight inflation, so I was quite surprised and concerned when there was 50 basis point rate cut in April.

Q: You would have been horrified at the GDP numbers as well at 5.3%. You have perhaps correctly distrusted the exact GDP numbers but surely the direction is lower and lower and getting rather bad?

A: There is no question that we are in the midst of a downturn. Things are difficult in output. Now the question arises - what can we do about it? I would continue to worry that high and unstable inflation is part of the malaise.

High and unstable is what is making it difficult for the firms to do their planning, to undertake investment and to be able to function harmoniously. So, if we want to set the platform for high and sustained growth, one of the elements of that platform has got to be a sustained war on inflation.

Q: What exactly is your view with regards to inflation with the CPI data as well as WPI? One of the views that came out from the economist table that the MSP increase of around 20% was the reason why the RBI possibly held off because there is a higher risk in terms of food inflation going forward. How exactly do you expect the trajectory on inflation to pan out for 2012 and possibly FY13?

A: We seem to be stuck in a spiral of a roughly double digit inflation. For months and months we are persistently in the roughly 10% CPI inflation range, I only look at the CPI. CPI is the inflation that matters to the household.

Household expectations are saying 12-13%. I would be thrilled and delighted if this inflationary tiger would just rollover and be nice but that is not what history teaches us. When a country gets into an inflation crisis, inflation does not subside all by itself.

Q: One would have thought that the political authorities would be the natural hedge against inflation because it is politically suicidal to have double digit inflation for three-four years in a row as you correctly point out. Yet, quite clearly the biggest problem for inflation I think is the fisc which is generating this aggregate 6% of GDP in the form of aggregate demand and probably fuelling inflation. What is your diagnosis of this four year old problem?

A: I am no admirer of the way India is handling fiscal policy, but we should be careful in how we thing about it. The exchequer will do what the exchequer must do. In lots of countries in the world, you have various fiscal problems. So, India is not alone in having fiscal difficulties. I would also point parenthetically that India has had sustained large fiscal deficit. So, in a way you want to explain the inflation crisis which is from 2006 onwards.

I am not so sure if you can pin it on the fisc because fiscal policy has been misbehaving for a very long time. Monetary policy is and should be the main story about inflation. The rupee is the invention of the Reserve Bank of India and maintaining the length of the rupee is the core business of the Reserve Bank of India. So, there is a split and that split is important. The exchequer will do what the exchequer must do.

We can advice the exchequer. We all have our views about what fiscal policy should do. I do not support large fiscal deficit. But let’s not lose sight of perspective. Inflation is finally and in the long term always a monetary phenomenon. Inflation is about the length of the rupee. The rupee is a creation of the Reserve Bank of India.

You do not get year to year fluctuations in fiscal policy or monsoon or whatever generating long term sustained inflation. Remember, we have been above the 5% upper threshold of CPI inflation in every single month from February 2006 onwards. This is not a short, quick, temporary burst of inflation. This is deeper monetary policy problem.

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Q: What according to you should the RBI do for the rest of the fiscal because most economist are also factoring in maybe the RBI will possibly move in July and maybe they would move a little more aggressively for the entire year but not – there is a divergent set of views at this point in time. You spoke about further tightening, give us a sense in terms of how exactly would you expect them to move?

A: I am not very focused on the tactical details so I am not going to be able to answer your question helpfully. But in my mind it’s crystal clear that the policy rate is very negative when expressed in real terms. If you think that expected inflation is around 12% which is what the households of India believe then you have got a very negative policy rate.

If you are an optimist and you think inflation will come back to double digit territory you still have a highly negative policy rate. So it seems to be very clearly that there is a problem, there is a gap. People like to say RBI raised rates 14 times, but I would always point out that the extent to which the policy rate was increased overall was less than the acceleration of inflation.

Actually through the entire period monetary policy was expansionary because the real rate went down and that’s what matters in the economy. We should recognize that monetary policy is way off track, monetary policy is grossly wrong today. We are in highly negative real rate territory and we have got to fix that.

I don’t feel strongly about what to do, how to do. I would just say that the latest monetary policy announcement was an opportunity lost in bringing the real rate back into meaningful positive territory where it would start reigning in inflation.

Q: We have seen a fall in manufacturing inflation numbers but food inflation has not come under control at all. There is and overall monetary argument but is there something more peculiar and specific that is not getting sorted out?

A: It is very useful to think of the overall CPI basket as tradables and non tradables, So, tradables are most manufacturing, so I may buy a ball bearing in India but in principle I could import if I want it. For all tradables the domestic price is just the exchange by the world price and that is rate multiplied where domestic monetary policies simply don’t matter.

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RBI has nothing to do with the world price of the ball bearing; RBI has nothing to do with the exchange rates. So, the real focus of monetary policy should be on non-tradables, it should be on everything else. It should be on food, services, rent and local economy.

In that sense I would actually be quite comfortable if we looked at inflation minused tardables as the main focus of monetary policy because we really cannot do much about tardable’s. That is why WPI is a phenomenally bad priced index for the purpose of monetary policy analysis because WPI is almost all tardables. It is precisely the stuff that RBI can do nothing about.

Q: The total composition of investment rate has been declining, it is no longer a slowdown, it’s a reversal. Is this all just a sentiment play?

A: It is. Ultimately investment is animal spirits, investment is optimism, investment is confidence. Investment is the guy who steps out and puts his neck on the line building a factory in the belief that when the goods come out - he will make profits. So there is no question that it is all about expectations.

We have done a lot in India in the last few years to contaminate that environment of expectations ranging from ethics problems, corruption scandals, populism, subsidies, fiscal problems, inflation crisis, bad communication by the RBI, bad monetary policy by the RBI.

This has added up to an entire picture of a government establishment in India that is unable to do the business of economic policy in a USD 2 trillion market economy. That is not exactly comforting for a man making the call of putting his money into building a factory.

Q: Can you share your view on the rupee? How does rupee’s weakness and depreciation tie in with the macro situation that we are dealing with?

A: We should understand that the rupee is a floating exchange rate, the rupee is a creature of the market, the rupee is as much created by the private sector as is Nifty. So we should analyse the rupee as the outcome of out market. Nifty and the rupee are the two main financial markets of India today.

Second point is that rupee depreciation is very good for India. With rupee depreciation, the tradable prices, tradable profitability goes up. The opportunity to invest in tradable businesses becomes more attractive as long as there is rupee depreciation. Of course, exporting becomes better.

The only important stabilization in India that takes place today is the rupee. This is because RBI does not understand how to do monetary policy correctly to stabilize the economy and because the ministry of finance does not do fiscal policy to stabilize the economy, we are left with only one leg in the stool of stabilization, which is the rupee. So, rupee depreciation is the only positive that is pulling the economy back today.

Q: How are you looking at growth GDP numbers in the coming years even if you don’t want to give it on a point on point basis since you distrust that index? Will we be stuck with this 5-6%; are we just back to the 90s?

A: I don’t think of it as stuck, I think that there are business cycles, there are fluctuations about a trend. Given that everybody is gloomy I should remind people that in terms of the long term trend growth let us not lose sight that India is an economy with high long term trend growth. We do invest 30% of GDP, we do have very low productivity and there are so many firms all across the country who have phenomenal investment opportunities.

You just have to buy state of the art machinery, you have to buy state of the art technology, you have to keep on deploying the latest and greatest ideas of the world that you can fetch over the internet and you get a productivity transformation in India. So let’s not lose sight of that micro-fundamental.

Now surrounding that long term trend growth of investment and catching up with world technology you got a business cycle laid on top of it. We are in the midst of a business cycle downturn and these things are part of life to some extent, all capitalism suffers from business cycle. We do a bit worse than a mature capitalist economy because we do not have a well functioning central bank and because we do not have the role for stabilization that fiscal policy can play.

We have only one stabilizer and that’s the rupee. So we will experience little more extreme boom and bust compared to what we see in mature market economies today. A useful analogy is 19th century United States, 19th century United States was where the industrial revolution was being put in, investment was taking place, new technology was coming in. There was really no institutional capacity, there was no central bank, there was no fiscal policy so you got a lot of boom and bust.

There were extremely good years, there were extremely bad years, that’s India. India has very extreme fluctuations. When times are good we are all euphoric, when times are bad we are all down in the dumps. But let’s keep this sense of perspective, let’s not lose sight that finally growth in India is a microeconomic phenomenon.

Growth is about CEOs going and doing things that increase the productivity of the company. Growth is about CEOs finding state of the art knowledge and technology from all over the world and deploying it into their business that goes on everyday. There are so many opportunities for doing that in India that’s what gives us trend growth.