Dipping inflation shows how wrong RBI has been all throughout….

The RBI adopted a hawkish stance on interest rates all through FY11 and half of FY12, taking cover behind what all central bankers do – high inflation. I’ve written several times about this. India’s inflation was not a worrying thing. It’s structure and reasons were different from what the classic factors and reasons are. And hence the response of the RBI Governor should have been different from what the classical response would be. Instead, Subba Rao continued with his mechanical ways, refusing to apply his mind to crafting a specific response; one that addressed the unique nature of Indian inflation. As a result, he contributed extensively to the GDP collapse of FY12 and FY13.

What is it about Indian inflation that was unique? Well, fundamentally the inflation was coming from food items, not manufactured goods where the RBI’s writ works better. But why were food prices rising? The RBI’s mechanical answer obviously is because of a supply demand mismatch; because farm productivity was lagging behind etc. Even if we accept this argument, the question that arises is: what can the RBI do to control this inflation via its bank rate mechanism? The answer is: precious little. But I’ll return to this later. Coming back to food inflation, the real reason was that there was more money in the hands of the poor, thanks to MNREGA and faster growth in the poor states of Orissa, UP and Bihar. For the first time, the poor were able to afford food. A hint of this was visible in the nature of the food inflation. Protein-heavy food products – like eggs, meat, pulses – and vegetables were on fire while cereals like wheat and rice and coarse grains were all sub 5%. The poor were finally starting to buy proteins and vegetables. So if the food inflation was because the poor were actually better off, then what was the worry? Conventionally, inflation is a tax which hurts the poor the most. That wasn’t the case in India.

But the RBI chose to go with a mechanical response. It increased bank rates 13 times in 18 months from April 2010 to Nov 2011, hardly helping food prices, but severely denting India’s manufacturing growth. The GDP growth plummtted right through FY11 and FY12, from 9.4% in Q1, FY11 to 4.25% in Q4, FY13, in tandem with the RBI’s rate increases. This was a case of a doctor giving medicines for malaria because he had been taught that even though the problem was actually a fracture in the arm! Or in today’s context, this is like looking for a cricket bookie in India when everyone knows that they are actually sitting in Dubai! But the RBI did exactly that. They kept increasing rates, because that’s all they know how to do. They’ve been taught in classic Keynesian economy terms that when inflation increases, banks must increase rates.

Not once did they consider that “core inflation” – essentially non-food, non-fuel inflation (or “manufacturing inflation” in other words) – on which they had some control through the interest rate mechanism was never the problem. In fact, in June 2012, Subba Rao was quoted in Mint: “although core inflation was moderating, a persistently high overall inflation, in the face of sharp slowdown in growth, pointed to “serious supply bottlenecks and sticky inflation expectations.” Exactly! Core inflation was moderating. There was a sharp slowdown in growth. And there were serious supply bottlenecks. So what should the RBI Governor have done? He should never have increased rates, but having made a mess, he should have dropped rates real fast. But Subba Rao is still a reluctant rate cutter. Even today, bank rates are at 7.25% way above the April 2009 number of 4.25%. I think the RBI owes an apology to the Indian corporate sector; and to all Indians.

The world over, central bankers are concerned with both inflation and GDP growth. Yet, Subba  Rao has chosen to ignore the latter and make the former his mission. His ignorance on the former made him do what he did; but his ignorance took a toll on the latter. Today, Subba Rao has realized his mistake as the May 2013 RBI statement admits “growth has decelerated continuously and steeply, more than halving from 9.2 per cent in the fourth quarter of year before last, 2010-11, to 4.5 percent in the third quarter of last year, 2012-13”. Subba Rao pretended – almost like a politician would – that inflation and the care of the poor was his only concern. Growth was someone else’s baby. And in order to prove just how “independent” he was, he was happy to give the cold shoulder to successive FMs – Pranab Mukherjee and Chidambaram – when they nudged him towards a better understanding of the subject. Subba Rao was determined he was there for the poor. But the poor were not the victims here. The poor were the ones who were driving up food inflation; a subject on which his rate hikes had very little impact!

Today, after four successive rate drops over the last year, inflation has actually come down, not gone up. Subba Rao never reduced rates voluntarily or out of conviction. It was like he was under tremendous pressure from Chidambaram and the industry. His was a grudging lowering of rates; not a wholesome belief. Today he’s been proven wrong conclusively. Today, headline inflation is down to below 5%; thanks to food inflation coming down. Food inflation, on which he has very limited, if not zero, control. In the process, manufacturing inflation has come down to below 2.5%, way below his own target of 5%. All this is happening in the backdrop of rising fuel prices – especially diesel. All those – mostly the BJP and opposition parties – who were complaining of diesel price hikes out of “concern for the poor” may want to re-calibrate their knowledge of the subject!

There are many factors that have helped inflation cool down. One of them is cooling petro prices and the consequent strengthening of the rupee (slight). But again, RBI’s rate increases has had no influence on global crude prices! India is just a lucky beneficiary of that fact. There is also a significant cooling of global commodity prices, as a result of which input costs have reduced, and in a hyper competitive slowing market, industry has dutifully passed on some of that cost saving to the people, pulling down prices. And finally, thanks to the drastic trouble that several sectors find themselves in – real estate, auto, durables, mobile handsets – they too have been forced to cut their margins and pass on price concessions in a desperate move to stay afloat.

The real truth is that Subba Rao messed up the Indian economy in the last two years. He increased rates without trying to understand the real underlying issues. He acted mechanically. He devastated Indian GDP growth, while hardly helping the inflation cause. If this is how “independent” regulators behave, I think we need less, not more of them…..