Issues of economic stability

Since Independence, India has been a stable country both politically and economically. In a way, economic stability and political stability reinforce each other.

Economic stability has three dimensions. The first is macroeconomic stability, meaning a non-disruptive balance in fiscal, monetary and external sectors.

There were fiscal excesses in India at different points in time, but the monetary measures checked the adverse impact of such excesses. External sector balance was maintained through a gradualist approach to opening up the economy to external forces. Second is financial stability, which has assumed an added dimension since the 1990s, after a series of systemic crises. The third is price stability, or control of inflation.

While credit must be given to the democratic spirit of the people for political stability, it is the economic thinkers and policy-makers, both in the government and the central bank, who should be given the credit for economic stability.

A stalwart among them was Dr C. Rangarajan, who continues to remain at the helm of affairs and has held sway over all major economic reform measures since the early 1980s.

In a fitting tribute to his contributions a galaxy of people felicitated Dr Rangarajan on his 79{+t}{+h} birthday on January 5. One of the issues that received attention during the proceedings was the problem of current inflationary pressures in India.

Issue of Price Stability

The Home Minister, Mr P. Chidambaram, mentioned that no tax could be more severe than inflation. Pointing out, in particular, the rising food prices, he wondered whether administered prices needed a correction. All factors that contribute to inflation should be understood and also all tools available to control inflation must be deployed.

Dr Kaushik Basu argued that the current price rise must be seen at two levels, one from a sector-specific and short-term viewpoint and, two, as a sustained or enduring price rise.

Very different policies may be required to address the two aspects. If the sectoral rise in prices, such as in food items, is because demand is out of sync with availability, then issues such as product supply and supply chains must be understood. If retail prices are far greater than farm-gate prices, then the impact of cartels of trade should be assessed.

In another separate interview the Finance Secretary, Mr Ashok Chawla, has argued to the effect that neither the government nor monetary policy can do anything more about controlling the present inflation.

Dr Rangarajan emphatically stressed that price stability could be one of the objectives of a central bank, but it must remain the most predominant objective of monetary policy. He added that one cannot brush aside monetary policy, saying that it cannot be effective in the case of food inflation.

Since food inflation feeds into generalised inflation, monetary policy does have a role in controlling food inflation too. He has always held that, of the various objectives, price stability is perhaps the one that can be pursued most effectively by monetary policy.

While the twin objectives of monetary policy in India — price stability and ensuring adequate flow of credit — stay put over time, a precise statement of these objectives and a framework for achieving them have evolved only since the mid-1980s.

Dr Rangarajan had been instrumental in providing a framework, designed on the basis of the interaction and relationships between the three parameters, namely money, output and prices.

Role of Reserve Bank

The Reserve Bank, by statute has the role of maintaining monetary stability, which could be considered to subsume both financial stability and price stability.

When financial stability was added as an objective of monetary policy in the late 1990s, it aimed at ‘maintaining orderly conditions in the functioning of financial markets'. But, currently it encompasses a broader arena of institutions, markets, regulatory policies and infrastructure.

One of the positive offshoots of the Rakesh Mohan Committee on Financial Sector Assessment of 2009 was the creation of a separate Financial Stability Unit in the Reserve Bank of India.

The Unit brought out its second Financial Stability Report last week, which is an improvement over the first, reflecting the considerable efforts that have gone into upgrading the methods and techniques to assess the health of the financial system and to analyse the potential risks to systemic stability.

But, in this milieu, the importance of price stability has been relegated somewhat to the background. What is more saddening is the sheer helplessness with which the inflation problem is being addressed.

What is clear is that inflation control does not seem to be receiving the attention it deserves. Second, the central bank's focus is diverted because of multiple objectives.

Third, there is no clear understanding of the factors contributing to inflation and in identifying effective tools to mitigate the inflation risk.

As in the case of the Bank of England, which brings out a quarterly inflation report, apart from a financial stability report, the Reserve Bank also should attempt to bring out a quarterly inflation report addressing both supply- and demand-side factors that could help in attuning timely policy measures to check inflation.