As policy observers, we need not be wedded to the notion that ‘in the long run we are all dead’. Indeed, the obsession with the immediate future has distorted the growth-inflation debate in India. This is evident in the analyses and predictions of monetary policy moves.
What is the monetary policy time lag in India? One would think that is a question of a few weeks, if not days. That would be quite at variance with what is accepted as the normal time lag for monetary policy moves to influence aggregate demand and price levels in an economy — a year or even longer.
What makes one think that the time lag is so short in India?
Indeed, the time lag for policy impact in India seems to be so short that followers of the Keynesian school — that advocates activist stabilisation policy to cure an economy’s ills — would be greatly enthused.
As for the adherents of the rational expectations and the real business cycle school, the (supposed) rapid-fire policy impact may not provide them any time at all — to even say that recession/depression/stagflation are “efficient market responses” to unattractive business opportunities.
What other inference about the time lag can we make when the general debate assumes that the Reserve Bank of India, with its policy moves, can impact a range of economic variables at short notice?
The RBI policy stance is speculated on after every data release every other week — be it GDP growth, industrial production, services sector activity, wholesale inflation, consumer inflation, balance of payments deficit et al .
For instance, if a high CPI number is released, everyone says that the RBI cannot ease at its next policy review; but, if weak industrial production data follow one day later, everyone says that the RBI will (or should) ease. As if the next move is going to immediately impact long-term trends!
Volcker effect
Missing in this entire process is a perspective assessment of what has transpired in the macro economy over the medium term.
The consequences of policy actions over the years and idiosyncratic approaches which countries can take towards particular issues — for instance, the stance on FX market intervention and its long-term impact — are all blissfully ignored in this hype about the short-term.
(The short time lag inference may be valid under some exceptional circumstances — quite like the situation Paul Volcker faced when he became US Fed Chairman in 1979 in the face of double-digit inflation and slumping GDP numbers.
Drastic action Volcker put through at that time significantly altered household and investor expectations about inflation and policy-makers’ commitment to low inflation. That, in turn, laid the foundation for a relatively quick economic turnaround in the US. Still, it was a matter of months; certainly not days or even weeks).
Potential output
Are we witnessing the time lag effect now? In the backdrop of such an environment, one wonders if the present high level of inflation in India is the consequence of the idiosyncratic monetary policy approach of the past many years. In other words, are we witnessing now the “time lag” effect of a policy approach which has been followed since the early 2000s?
If so, has monetary policy in the past decade been too lax in relation to the potential output levels of the economy? Putting it differently, what is the non-inflationary growth potential of the economy: is it less than 8 per cent (as growth beyond potential generates inflationary pressures)?
Measuring potential output sure is no mean exercise – if the global experience is any indication. Like the joke about the two-handed economist or economists’ views exceeding their own number, different estimates of potential output have been produced, based on different parameters.
But a decade of economic trends and experience is quite something to draw upon for inferences and policy inputs.
That experience tells us that the Indian economy is straining to sustainably produce annual real growth above 5 or 6 per cent.
Flogging the economy beyond that level with easy money only produces stubborn high inflation. In other words, beyond a point, more of the nominal growth comes from price level changes instead of real output growth. Output even stagnates, landing us in stagflation.
Between 2000 and 2012, while real GDP rose 120 per cent, nominal GDP increased 350 per cent.
This means prices rose close to 300 per cent in this period — a CAGR of nearly 12 per cent. (This is the price level increase in overall GDP including services).
Prices increases
One cannot escape the fact that India has now become a very high cost economy.
A wide range of goods, services and assets have experienced some of the sharpest price increases we have seen in recent memory even as real growth stepped up a little.
Is this level of price increase at all useful to the common man? One is not sure. (The Phillips Curve advocates have to confirm).
If somebody has benefited from the sustained high inflation, it is the Government. Its large debt burden (with increasing fiscal deficits every year in absolute terms) is simply inflated away.
Inflating debt away is a refined way of defaulting on it. Not many notice or understand it. And, there is no need for tough policy to produce at least smaller deficits.
After a decade of relatively rapid output growth but even larger increases in prices, the basic questions have to go beyond the short-term hype about monetary policy.
Public debate has to focus on what has been the long-term impact of the policies which have been followed for some time.
(The author is a Chennai-based financial consultant.)