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Rajan’s Monetary Policy Foray
Pursuit of Low Inflation
S L Shetty

The Reserve Bank of India is not justified in holding on, almost continuously, to some discredited ideological position of monetarism and thereby hurting economic growth.


onsidering the situation into which the nation’s economy was pushed during the past three to four years when the central bank steadfastly took a narrow monetarist policy stance with the objective of fighting inflation that is largely supply-induced, there were expectations that the new Reserve Bank of India (RBI) Governor Raghuram Rajan would change course. It was hoped that he would indeed heed the pleadings of the prime minister, Manmohan Singh, “that the time had come to look at the possibilities and limitations of monetary policy in a globalized economy” and provide for “a fresh thinking” in helping “to carry on with implementing social and economic changes in a complex economy”. This was not to be. Again, with a rise in the wholesale price index (WPI) in July 2013 (after a continuous fall over 10 months from July 2012 onwards), this on the eve of the latest mid-quarter monetary policy review of 20 September 2013, the RBI governor surmised that “inflationary pressures are mounting”. With such a deduction, and determined to establish a nominal anchor which will allow the RBI to preserve the internal value of the rupee, he has raised the repo rate by 25 basis points. As he put it: “The intent here is that when the repo rate becomes the effective policy rate, it should be consistent with inflationary conditions in the economy”. Thus, the intention of pursuing a single objective, one of inflation control, with a single instrument, namely, the repo rate, has been set in motion. Subbarao’s Legacy

The author thanks his colleagues, Bipin K Deokar, R Krishnaswamy, Shruti J Pandey, Anita B Shetty and Nishigandha R Lokhande, for their assistance in preparing this article. S L Shetty ( is advisor to the EPW Research Foundation.

Indeed, this is the edifice on which the previous RBI governor, D Subbarao, had built his monetary policy stance for four years and raised the repo rate 13 times from 4.75% in March 2010 to 8.50% in October 2011, that is, by 375 basis points.
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In fact, the effective tightening was even more, 500 basis points, as the operational policy rate shifted from reverse repo rate (absorption mode) to repo rate (infusion mode), as revealed by Subbarao himself (Subbarao 2011). What is more, in his swan song before laying down office last month, Subbarao admitted, from the benefit of hindsight, that those baby steps in monetary tightening were not enough: “I must admit in all honesty that the economy would have been better served if our monetary tightening had started sooner and had been faster and stronger”. There is no empirical basis for this expectation. Much of the V-shaped growth in the post-Lehman period was due to deep expansionary impulses not only from monetary measures but also from fiscal ones. Such a fiscal expansionary impulse was anathema for a central bank imbued with conventional monetarism. A series of policy statements from the RBI during Subbarao’s term in office provide a plethora of explanations for this restrictive monetary policy framework. Amongst them, three factors stand out: a high fiscal deficit having implications for inflation, the persistence of inflation in protein-based items of food, and wage increases, particularly in rural wages. An objective analysis of these factors by an impartial observer would suggest that they do not stand empirical scrutiny and hence cannot be the basis for adopting such hawkish monetary steps. On the fiscal deficit question, the monetarists have a very biased perspective; they seek compression of public expenditure but they give no attention to revenue side of the fiscal balance. In fact, with respect to the state of the Indian fisc, there are a number of drawbacks on the revenue side. First, there is very low tax-to- GDP (gross domestic product) ratio because of low revenues collected from direct taxes. The marginal tax rate is the lowest amongst many large economies, and what is more, there is hardly any wealth tax, capital gains tax and inheritance tax. Second, excessive dependence on indirect taxes has serious implications for inflation as the incidence of indirect
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3 10. it is the combined finances of central and state governments that matter.COMMENTARY taxes is passed on to consumers. To quote former governor Subbarao: Unlike the growth-inflation trade-off.7 26. Economic & Political Weekly EPW october 26.3% of GDP in 2009-10 to 6. food inflation has two causes.3 8.36 9. Source: WPI Inflation: Office of the Economic Adviser and EPWRF Online Database. and the revenue deficit has declined from 5. As per such combined finances.3%. The consequential growth prospects and likelihood of improved economic activity would have further contained inflationary expectations. Table 1: WPI and CPI Inflation Rates Monthly y-o-y Rates (%) Year End All Commodities the RBI’s thinking is both circuitous and far-fetched.8%.5 6.16 5.3 1.2 8.7 3.4 15.7 7. A few substantive statements made by the RBI on these subjects are worth examining. the significant increase in rural wages triggered by the Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS). the RBI has refused to respond with a more moderate monetary policy stance. Even the GFD of the centre alone has been brought down from 6. It is not as though the fiscal deficit has been on the run. both of which are outside the purview of monetary factors. despite noticeable reduction in the fiscal deficit as a proportion of GDP.5 -4.2 6.6 6. The need for making growth inclusive is incontestable.8 9.1 8.9 18.1 (46. These have to Monthly WPI Inflation (2004-05 = 100) Food (Food Industrial Input Energy (Fuel and Core Inflation Articles + Food (Non-Food Article + Power + Crude (Mfg Products – Products) Metallic Minerals + Petroleum) Food Products) Other Minerals) CPI-IW Monthly CPI-IW 2001= 100 Food Group Fuel and Light Core Monthly CPI-All India 2010 = 100 CPIFood.4 6.0 (55.10 (24.9 5.69 5.5 5. Fuel and Core All India Beverages Light and Tobacco Weights Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 (100. and second.8 8.3 9.2 14.2 13.0 10. Suffice it to say.8 8. the possible trade-off between inclusive growth and inflation has not received much attention.2) 12.0 16.2 (47.4 6.6 8.5 8.4 12.9) 11.2 8. and to the extent there is some inflationary implication for such steps.4 8.71 1.72 7.2% to 3. at any rate in the short-term. which are a constituent part of the development process.3 18.4 3. Data analysed by EPWRF. which are part of the development process.0 7.2 10.0) 6. If these are conceived of as a risk factor for food inflation. On the question of food inflation and inflation arising from wage increases.5 1.6 6.6 11.65 10.1 20.4 (4.0 14. which has originated in supply shocks.5% to 4.49) (40.9 3.4) 3. Core inflation.8 8.71) (9. there are structural causes. Be that as it may. has drastically come down.8 10. but what is being argued is that monetary policy should have responded with easing of interest rates during the latter half of 2011-12 and 2012-13 when core inflation came down rather noticeably.6 7. beverages and tobacco and fuel and light with CPI-all India. as per WPI.2 12.4 10.3 11.7 8.80) 9. Such redistributive goals have growth implications and need not result in generalised inflation.65 4. arising from the changes in the consumption habits of the populace. as the RBI has done.9% in 2013-14 (BE).0 2. but it is important to recognise that policies aimed at inclusion can stoke inflationary pressures. and the revenue deficit from 5.0 (15.7 7.7 3.2 4.4 13. food inflation arising from proteinbased items is the result of structural changes.9 8.9 18. and for the general level of inflation. Higher public investment contributes to improved economic climate.7 11. as referred to above.77 4. there have been repeated increases in minimum support prices (MSPs) which have contributed to increases in foodgrains output and better food security.0 8.7 6.9 7.5 6.8 8.9 (100.5 12. The RBI has admitted that “The containment of GFD in the face of shortfall in revenues has been brought about by scaling down plan expenditure and capital expenditure” (RBI 2013: 54). normal monetary measures should be able to absorb their shocks.3 12.4 1.4) 2.7 1.6 16.6 2.9%. As shown in Table 1.4 16.6 Core inflation (CPI-IW 2001= 100) derived by deducting food group and fuel and light with CPI-IW. Second. both in wholesale prices as well as in consumer prices.7% to 2. as in 2009-10 and 2010-11.79 6.3 7. better tax collection and a possible reduction in the fiscal deficit.68 7.5 7.2 9.9 9. the gross fiscal deficit (GFD) has fallen from 9.5 7.0) 6. From the viewpoint of fuelling aggregate demand.8) 1.58 5.2 2.0 10.9 8. I could mention two examples here: first.2 6. Similarly.0) (49.4 11.2 7. as the government has repeatedly emphasised. Therein lies one of the sources of reduced investment demand in the economy.7 8. there will be no respite for the economy from the central bank’s hawkish monetary policy measures. Core inflation (CPI: All-India 2010 = 100) derived by deducting food.0) 6.4 (100.0 3.9 (6. The record of the past two decades in the post-reform period suggests that there is scope for a more nuanced and balanced approach to fiscal operations. We are not contending that monetary policy has no role to play even in periods of supply shocks that have produced some generalised inflation. it is food inflation that has been responsible for the high level of inflation that the Indian economy has faced. First.2 9. Vast changes are taking place in the household consumption basket and they have brought about increases in the share of protein-based food items.6 3.9 9. 2013 vol xlvIiI no 43 19 .9 0. inflationary implications of the proposed Food Security Bill (RBI Bulletin 2011: 2031).7 -2. A steep tightening of monetary policy in such situations is unnecessary as it has adverse implications for growth.3) 9. and is thus iniquitous.4 8.

Therefore. putting children in school. the effort is both futile and wasteful” (RBI 2012). about Rs 1. the benefits of social banking have considerably narrowed during the past four to five years. it is easy to forget that monetary policy is also about reducing hunger and malnutrition. It would be suicidal to hold back the growth process in the meantime with a sledge-hammer. the conduct of monetary policy will continue to condition and contain perception of inflation in the range of 4. A full account of these have been provided in a separate publication (EPWRF 2013: 257). is the world’s largest abstract and citation database of peer-reviewed literature with tools that track.5% rate is imperative in the Indian context. Finally. there is the claim of quantitative achievements but Subbarao’s own words disclaim them: “I am also conscious that the bulk of our effort so far has been from the supply-side – opening branches. one runs the risk of losing touch with the real world. In the Reserve Bank. We therefore need to question the broader inflation objectives of the RBI.5% – let alone a 3. We have introduced a number of initiatives. about 56% of term deposits were at deposit rates of more than 9%. as the Indian economy is faced with. analyse and visualise research. village immersion programme for our younger officers. which is one of the causes for continuing financial exclusion. published by Elsevier. both in terms of WPI and CPI. it is impossible to achieve such a low level of inflation. as related by Subbarao himself. and in any case. After the RBI began to raise the policy rate in March 2010. have not been lent to them. A second example of biased performance in policymaking during the past october 26. Considering these features. which should have gone to agriculture or small-scale industries or other persons of small means.34. creating jobs. even the target of 40% set for public sector banks has not been fulfilled. immense. The revised guidelines issued in October 2012 have not only reintroduced the direct agricultural advance provision in respect of corporates.0%-4. Keep your ear close to the ground.scopus. the share of priority sector advances in total bank credit has persistently declined from 44. thus rendering the directed credit arrangement a nebulous concept. These sentiments are not imaginary. With your mind space fully taken up by issues like interest rates. if the aggregate loan limit per borrower given in favour of corporates exceeds Rs 2 crore.0% to 4.1 During the past two years. to mention some of the important ones. First.5%. This is in line with the medium-term objective of 3.5%. Some degree of trade-off between an objective of 6% to 7% inflation in contrast to targeting a 4. down from its earlier trend rate of about 7. vol xlvIiI no 43 EPW Economic & Political Weekly . conferences with frontline managers. on that count. at the end of March 2013. which affect the poor the most. Please visit www. it averaged around 5. which it has set out as follows: It is important to re-emphasise that although inflation has remained persistently high over the past two years. monetary measures cannot be the sole determinants of such low inflation. At the end of March 2009. Given this record. building roads and bridges and increasing the productivity of our farms and firms. few years concerns the inclusion of large-size accounts under the “priority sector” category. Scopus has begun indexing EPW articles and soon all articles from 2007 onwards will be indexed. there have been persistent increases in deposit and lending rates of scheduled commercial via your institutional subscription to that database. almost continuously. Its potential to hurt market sentiments and sentiments of investors is. Manmohan Singh told him: Subbarao.COMMENTARY be accepted as facts of life.600 crore of bank funds. the RBI is not justified in holding on.0% to 4. beyond doubt.5%. Here. Many south-east Asian countries have experienced high inflation during their high-growth phases. a few examples are presented to bring home the point being made. I have followed this wise counsel to the best of my ability. Supply factors have a dominant role to play in inflation control. macroeconomic experiences so far are of any guide. the corresponding proportion of term deposits in March 2012 was as high as 80%. If this is all that happens. if 20 All these are true. when he called on the prime minister after his appointment as RBI governor. In other words. In a developing society with vast scope for structural changes. but despite those outreach programmes. town hall shows and meetings with focus groups. The outreach programme of village visits by top executives of the Reserve Bank. appointing BCs [banking correspondents] and opening accounts that remain largely inoperative. 2013 EPW on Scopus Database EPW is now indexed on Scopus. conventions of business correspondents. the balance is allowed to be treated as indirect finance for agriculture. Scopus. growth impulses get squeezed and there are adverse consequences for employment generation and other aspects of inclusive growth.2% in March 2013. during the 2000s. the achievement of an inflation rate of 4. they have been deprived of the corresponding loan facilities. Consequences of Earlier Actions The RBI’s tight monetary policy stance has manifested itself in a variety of macroeconomic disturbances. Subbarao then goes on to say: In the five years that I have been at the Reserve Bank. Obviously this In a situation of structural changes and periodic supply shocks. to some discredited ideological position of monetarism and thereby hurting economic growth.0 per cent inflation consistent with India’s broader integration into the global economy (RBI 2012a: 9). you are moving from long experience in the IAS into the Reserve Bank. When strong monetary measures are deployed to achieve such a low level of inflation. etc. but also doubled the limit from Rs 1 crore to Rs 2 crore.7% in March 2008 to 36. some degree of higher prices serves as an incentive for some sectors. tightening the interest cost in the economy. What is more.0% rate as a medium-term objective – cannot be in sight for quite some years to come. partnership firms. It is interesting that. they are policy induced and the public at large has to be educated about the imperatives of some inflation arising from them for better growth. on the performance under financial inclusion. liquidity traps and monetary policy transmission.

Thus. FRE: First Revised Estiamtes. Size-wise.3 Growth in GDP and employment have suffered.2% of sales in H1 of 2008-09 to “Performance of Private Corporate Business Sector during First Half of 2012-13”.6 – (-) Not Available.5 14. Table 2: Trends in Fixed Capital Formation Rate in the National Economy and in Different Sectors Year Gross Fixed Captial Formation As Percentage of GDP at Current Market Prices Aggregate Of Which Fixed Capital Public Private Household Formation Sector Corporate Sector Sector 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 (FRE) 2012-13 (PE) 28.8 7. that is. the small companies always have high interest cost.5 13. The continued moderation in corporate investment intentions in 2012-13 may be attributed to the above developments.aspx) increase in banks’ cost of funds has to be borne by borrowers.7 30.3 7. January.4% in H1 of 2012-13.4 7. In the case of all sectors and all-size companies. RBI. Bulletin.2% in the first half of 2008-09 to 3. has also remained poor (RBI 2013a: 87). so have domestic savings and investment.7% in the first half of 2012-13. The stresses on the external sector have finally culminated in a sharp depreciation of the rupee.6 13.2 11 9. which acts as a barometer for investment climate. It of GDP in 2007-08 to 9. 50 and p 52. there has been an all-round increase in interest cost which appears to be the only factor responsible for drastically reducing the net margin of companies. in this phase their cost has doubled from 4.3 32. Performance of the capital goods sector. and more significantly. These adverse sentiments are particularly reflected in reduced growth.2 10.9 7. close to the level that prevailed seven years ago in 2004-05.2% of sales. 2013 vol xlvIiI no 43 21 . Issued with Supplement. therefore. with sizeable negative profit margin during the past two (http://rbi. and within it.3 31.7 – 12. the manufacturing companies. Economic & Political Weekly EPW october 26. the fall has been equally steep.7 30.4 – 9.7% in 2011-12. Source: Central Statistics Office (CSO).3 10. the sector has experienced the sharpest fall in its fixed capital formation rate (Table 2). the profit margin has declined from 9. Such an increase in bank loans is depicted in Figure 1.9 8 8.2 13 13. the rising incidence of interest cost has hit the private corporate sector. To quote an RBI study in this respect: As regards the financial performance ofthe non-financial private corporate sector. In the case of manufacturing firms. PE: Provisional Estimates.8 12.7 31.1 11.9 32. not surprising that because of the paucity of investible resources with the private corporate sector.6 6. There have been persistent declines in the portfolio non-resident Indian (NRI) deposits and other capital inflows as also in current flows.9 10. the smaller companies (Figure 2). profitability and investment of the private corporate sector. interest cost as percentage of sales has jumped threefold from 1. A similar increase has taken place amongst the manufacturing firms.3 31. Size-wise. Figure 2: Trends in Interest Cost and Profitability of Different Sizes of Companies (As % of Sales) (i) Large Companies (ii) Medium Companies 11 9 7 5 3 1 H1 H2 H1 H2 H1 H2 H1 H2 H1 201213 2008-09 2009-10 2010-11 2011-12 (iii) Small Companies 9 7 5 7 6 5 Interest cost Net margin 4 3 Net margin 3 1 -1 Interest cost Interest cost 2 H1 H2 H1 H2 H1 H2 H1 H2 H1 201213 2008-09 2009-10 2010-11 2011-12 Net margin -3 -5 H1 H2 H1 H2 H1 2010-11 H2 H1 2011-12 H2 H1 2012-13 2008-09 2009-10 Source: RBI (2013).COMMENTARY Figure 1: Loans at Different Interest Rate Slabs for Public Sector Banks (i) Demand Loans 19 Maximum 17 17 (ii) Term Loans 19 Maximum Rate of interest in % 15 Rate of interest in % 15 13 13 11 Minimum 9 11 Minimum 9 7 3/07 9/07 3/08 9/08 3/09 9/09 3/10 9/10 3/11 9/11 3/12 9/12 3/13 6/13 7 3/07 9/07 3/08 9/08 3/09 9/09 3/10 9/10 3/11 9/11 3/12 9/12 3/13 6/13 Source : rbi. This ratio has dipped from 14.5 8. In the case of the corporate sector as a whole.3% to 9. the small companies have suffered the hardest. they show the persistent increases in loan rates of banks after the middle of 2010. pp 49. the sales growth decelerated for six successive quarters and reached the lowest since Q2:2009-10. These data based on control returns relate to minimum and maximum rates of interest on loans.7 11. More concretely.6 29.

Duvvuri (2011): “Monetary Policy Dilemmas – Some Reserve Bank of India Perspectives”. October. as Rajan has done.50% has been done to raise the status of the repo rate to that of a unique effective policy rate (now at 8. It is promised to have better depth in the financial markets. that he shall not allow undue speculation on the rupee. – (2012a): Monetary Policy Statement of 2012-13. Raghuram Rajan firmly asserted: “(R)ecognizing that inflationary pressures are mounting and determined to establish a nominal anchor which will allow us to preserve the internal value of the rupee. Inflation. It is obvious that a number of structural factors. Bangla Sahib Marg New Delhi 110 001 Ph: 41561062/63 vol xlvIiI no 43 EPW Economic & Political Weekly . reduced savings and investment. RBI Bulletin. etc. provide for many more action points than just raising the repo rate. the world economy trends. also believe that maintaining low inflation is the central bank’s job. and the fact that bank funds have been rendered scarce. Government of India Subbarao. was moderating. that proves the point presented here. 26 September. which in turn have been largely attributable to steep increases in interest cost and erosion in the sector’s profitability. – (2012): Bulletin. Regional Spreads and Database Issues. and for this purpose. A major reform proposed concerns the foreign exchange market.4 billion.COMMENTARY The fixed investment rates of the public sector and the household sector have. Rajan’s Repo Rate Increase In his maiden monetary policy statement of 20 September 2013. The unusually high interest burden borne by the small enterprises is one example. A Speech at the Stern School of Business.Report of the Committee on Financial Sector Reforms. This is what Rajan has aimed to do. which has made many projects unviable.” Two swap facilities provided to banks – one for NRI deposits and another for foreign currency borrowings – have already brought in about $1. at the same time. The financial markets reacted adversely because this measure has gone counter to the series of reform hopes held out by him in the statement issued on taking office on 4 September 2013. A Study undertaken as a research project awarded to EPW Research Foundation by National Bank for Agricultural and Rural Development (NABARD). all unincorporated enterprises. References EPW Research Foundation (2013): Agricultural Credit in India: Trends. April 17. … Better that investors take positions domestically and provide depth and profits to our economy than they take our markets to foreign shores. issues associated with household behaviour like demand for gold. – (2013a): Bulletin. It must be admitted that the above two policy statements of the new RBI governor made on 4 and 20 September. relative stagnation in employment. including holding meetings with some foreign banks which are active in the NDF market. April. acceleration of financial development and financial inclusion. available at Delhi Magazine Distributors Pvt Ltd 110. New York University. interspersed by a third one in The Mint with an attractive. however. Rajan’s relevant writings. including the Report of the Committee on Financial Sector Reforms (Planning Commission 2009) have opined that the RBI should formally adhere to a single objective of low and stable inflation. amongst many. “We cannot create depth by banning position taking or mandating trading based only on well-defined ‘legitimate’ needs. 2013 bring in about $15 billion to $20 billion in the next six months. it is its primary job. and stresses on the external sector accounts – are all attributable to monetary policy alone. generally stood their ground. which made it necessary to shift focus to the consumer price index (CPI). or that other objectives of monetary policy such as growth and financial inclusion get undermined by the inflation control measures. The woes of the private corporate sector have been essentially due to the drying up of investible resources. Even the reduction in the “marginal standing facility” (MSF) from 10. it is to be recognised that monetary policy operations do have an influence on these activities and the monetary authorities cannot be oblivious of the harm that their policies are inflicting on the economy because those policies have a single-minded devotion to inflation control. September. They are all definitely welcome. The sector is also largely dependent on the banking system from where it has suffered in two ways: high cost of borrowings. weaker sections and persons of small means. Note 1 Priority sectors are said to be historically neglected sectors of the economy such as agriculture. have been contributing to the depressed levels of activity in the economy. Under the perceived situation of mounting inflationary pressures. more steadily to a single instrument of short-term interest rate (repo or reverse repo). the disadvantages inflicted on the marginal sectors and sections of society far outweigh the possible benefits that are expected from policy measures for development and inclusive growth. There are a number of other proposals which are aimed at development and inclusive growth. “A Case for India” (2013 Project Syndicate). interest rates have got to be raised. The governor has also given firm indications.50%). It is not our intention to posit here that the series of malaise faced by the national economy – low growth. December.25% to 9. RBI (2011): Bulletin. A caveat though that should be entered is that in a situation of high interest cost. the difference between the MSF rate and the repo rate has thus been brought down to 100 basis points. the only weapon the central bank has for controlling inflation is the interest rate. indeed. small-scale industries. they are expected to october 26. But. regulatory and infrastructural issues. They believe that operating under a free-market economy. corporate sector’s depressed investment sentiments. The markets 22 cannot realise that those economists who have innate faith in free markets and financial sector reforms. Planning Commission (2009): A Hundred Small Steps . – (2013): Annual Report 2012-13. Far from it. and this will help arrest rupee depreciation. aimed at hitting the non-delivery forward (NDF) markets for the rupee trading abroad. like Rajan. we have raised the repo rate by 25 basis points”. August. as measured by the WPI.