Monday, October 24, 2011

RBI is wrong in increasing interest rates…..this inflation is harmless

The RBI is responsible – amongst many other things – for keeping a check on inflation. It has been using the same tool – raising interest rates – over and over again. In fact, it has increased interest rates some 11 times over the last 18 months. However, the RBI has totally failed in checking inflation. Rather than change its approach, it is likely to increase rates again today. It’s time that the RBI explains itself. Since the RBI Governor reports to the Finance Ministry, it is important that Pranab Mukherjee seek an explanation. It’s also important that we reset the inflation target to 8% rather than the traditional 5%. This post will explain why.

What has been the RBI’s strategy really? To squeeze credit out of the system so as to tamp down on demand. Nothing wrong with this theoretically, except that the sectors of the economy where excess demand is causing inflation, have already been tamed. There is very little inflation now in Real Estate, consumer durables or automobiles which are interest rate dependent. By increasing interest rates every few months, the RBI is only reducing growth in these sectors; the automobiles (4-wheelers) sector has gone into de-growth for instance. And none of the rate hikes have helped reduce inflation.

The reason for this is not difficult to understand. We are talking of “Headline” inflation which has been kissing 10% for the last couple of years. In India, we measure WPI (Whosesale Price Inflation) since CPI (Consumer Price Inflation) is not available fast enough. The WPI has three components. One is inflation in “manufacturing goods” – which has a weight of 65%; the 2nd is inflation in “Fuels and Power” which has a weight of 15% and the 3rd is inflation in “Primary Goods” (including food articles) which has a weight of 20%. It’s interesting to note that inflation in manufacturing goods is only around 5.7% or so. Inflation in fuels is dependent on global factors and how the rupee fares against the dollar. There has been inflation this year in fuels (12.3%); but last year, inflation was actually negative (-2.2%). RBI’s rate hikes have negligible – if any at all – impact on inflation in fuels. The overall high inflation is a result of high inflation in primary articles – mainly food – running at between 15-20% per annum. I fail to understand how the RBI’s rate hikes will reduce food inflation.

The real reason for food inflation was brought out brilliantly in a study done by Sajjid Chinoy of JP Morgan recently. He points out that there are several reasons for inflation in food articles but primarily, it’s the impact of the NREGA (National Rural Employment Generation Act) which was launched in 2005 by the UPA-1. In the pre-NREGA period (1999-2005), nominal wages (wages inclusive of inflation) grew at an average annual rate of just 2.7%. Post NREGA (2006-2009), average nominal wage inflation has been 9.7%. But in the Jan 2010 – May 2011 period, the wage inflation has really surged to nearly 20% (in fact 22% in May 2011). Wage inflation is obviously good news for the poor who receive these wages. In addition to NREGA, Chinoy argues that there are other factors which have improved the availability of money in the hands of the rural poor: a sustained rural infrastructure thrust over the last few years; higher MSP (Minimum Support Price) paid to farmers and an increased “urbanization” of the rural economy. Taken together, the rural folks are raking in more money than they ever have. The nominal wage increases have also increased the real wage increases (wage increases, net of inflation). While in the 1999-2005 period, real wage increase was flat (no improvement in standard of living), in the 2005-2009 period, it was just 2% (perhaps because inflation ate away into the nominal wage increases). Post 2010, however, the real wage increases have been of the order of 10% (in fact, 14% in May 2011). Clearly then, the rural folks are happy. This is the best they have ever had. The inflation is not hurting them; in fact inflation is happening as a result of more money flowing into their hands. It’s the distribution of wealth that is leading to inflation. Not the conventional factors which RBI is accustomed to handling.

I have argued in the past that urban folks like us are not affected much by inflation. We may feel so, but in reality our standard of living is improving every passing year. Annual salary increases in urban areas have never been less than 12-15% per annum (always more than inflation). The only time this was disrupted was in 2009 when corporates cut salaries in some cases and didn’t give increases in some other cases. Since then however, salary growths are back to normal. Why PLUs (People Like Us) complain about inflation is because its human nature to complain about cost increases. On the other hand, no one likes to talk of salary increases! If our salaries were not rising fast enough, concerns of inflation would have been right. But I don’t think there has been a single year (with the exception of 2009) when salary increases have been less than inflation. The only ones who are really get hurt by the inflation are the urban poor – those who don’t have regular employment (drivers, maids, unskilled workers etc) and who depend on the generosity of the well off. And we all know that we well off folks can be extremely selfish – refusing to share our wealth while talking of having more inclusive talk in the same breath.

The RBI would do well to recognize this fundamental tectonic shift happening in the Indian economy. There is a huge distribution of wealth taking place. This is desirable; not something that needs to be curbed. The urban middle class may complain – but their salary increases are taking care of the inflation. There is no reason for the RBI to sweat.

That’s why the new target inflation should be 8% rather than the traditionally held view of 5%. In the day of 5% target inflation, the rural poor were being marginalized getting a 0% real wage increase. With more inclusive growth happening since the days of NREGA, it’s ok to have an 8% target for headline inflation.

How can we leave out the implications of this inflation on politics? Since the inflation is a result of higher wages in the rural areas – and thus not a matter of concern for the rural folks – the Congress is likely to benefit from it. The NREGA has been much criticized for being an “unproductive” scheme. Indeed, much of the work given out under NREGA is not helping build good quality and useful rural infrastructure. That needs a correction. But the fact is that sometimes a dole of this nature is a good thing – even if it is unproductive – especially if vast sections of the people are able to get better food to eat as a result of it. Poverty is one thing – but malnutrition is quite a lot more severe. The BJP is a more urban focused party and is bound to make much noise about the inflation. Inflation may be a matter of concern for the urban middle class (unfairly so) – but in the electoral battle, the middle class has a small weight. The parties that win the rural heartland will win the electoral battle.

The real truth is that the RBI has not understood this distribution of wealth part adequately. It is wrong in still targeting a 5% inflation rate. This inflation is harmless. By increasing rates, the RBI is only hurting industrial growth. Already industrial growth is down to less than 5%. If this continues, industries may shut down (already some industrialists are talking of shifting production to other countries). This will lead to joblessness. How this helps the country is something that the RBI must explain to the people. And to the Finance Minister. It’s time Subba Rao answers some tough questions…..

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