How RBI can cut rates without (really) worrying about inflation

If PDS were to be expanded to cover non-cereal food items too, controlling food inflation at the cost of keeping the economy repressed would not be as a much of a political necessity as it is today

NEWDELHI: Reserve Bank of India (RBI) governor Shaktikanta Das’s comment that no one had expected gross domestic product (GDP) growth to slow to as low as 5% could be an indication that the central bank’s monetary policy committee (MPC), which begins its two-day meeting on 4 October to decide on policy rates, may recommend a sharp cut in the interest rate.

The Indian economy expanded by 5% in the three months ended June, the lowest in six years. How much of a rate cut can one expect RBI to announce in October?

A September 15, 2019, column in Hindustan Times asked for a one percentage point cut in policy rates. Writing in the Times of India on Tuesday, Arvind Panagariya, former NITI Aayog vicechairman and professor of economics at Columbia University, has asked for a 50 basis point cut in policy rates. One basis point is one hundredth of a percentage point.

The usual argument against sharp cuts in interest rates is that they overheat the economy because of an equally sharp increase in the inflation rate.

Interestingly, Panagariya has asked for reconsidering the target band of retail inflation in India. “Unlike a mature developed economy, a rapidly growing developing economy undergoes rapid and constant restructuring. Changes in relative prices of different activities provide critical signals for this restructuring. But given downward rigidity in prices, low inflation limits the space for relative prices to move. This calls for moderate inflation at rates such as 5-6%,” he has argued. RBI’s current comfort level is 4% plus or minus two percentage points.

Panagariya’s argument is salient in the wake of the recent surge in food inflation (it was 7% in urban areas in August 2019), which accounts for almost half of India’s retail inflation basket. If food inflation continues to rise, then RBI will be forced to raise interest rates. This will make matters worse in a slowdown.

Still, an analysis of consumption data from the National Sample Survey Office (NSSO) suggests that there is some merit in reconsidering the present inflation-targeting framework in India. Here’s why.

The inflation targeting framework is based on the premise that lowering interest rates gives a boost to both investment and consumption demand when economic activity is weaker. Similarly, when aggregate demand is too high to be satisfied by production, raising rates can give a demand shock to the economy and restore equilibrium. This mechanism primarily works through the non-food economy. It is unlikely that consumers would seek formal credit to finance food consumption. Indian farmers mostly practice small-scale farming with very low capital intensity.

However, the non-food market in India suffers from a large inequality in consumption expenditure. According to the latest (2011-12) Consumption Expenditure Survey (CES) carried out by the NSSO, the top 10% of the households accounted for more than a third of total non-food expenditure in India. The share of the bottom 50% households in non-food expenditure was less than 25%. Food consumption has a lower inequality. The bottom 50% has a share of more than onethird in total food expenditure, while the top 10% accounted for just 20% of it. (Chart 1 A and 1B)

The NSSO numbers probably underestimate the consumption of the rich in India. The 2011-12 CES puts the average monthly per capita expenditure of population in the top 90%-95% in urban and rural areas at Rs 2,886 and Rs 6,383 respectively. This is too low to be true. This inequality also means that using interest rates to influence growth rates is dependent on a very small share of population, which has a disproportionately large share in total consumption expenditure. Put simply, it is about making the rich feel good.

Here’s one statistic which can put this in perspective. According to the 2015-16 National Family and Health Survey, only 6% of households in India owned a car. This probably means that the current crisis in the auto sector – car sales have been declining for a year now – could be the result of what has been happening to the incomes and preferences of the richest 10% of India’s population.

There is another side to the inflation story in India though. Given the fact that the poor spend a much larger portion of their incomes on food, they are extremely vulnerable to food inflation.

This also means that a large section of this population might not have suffered a lot due to the slowdown. On the contrary, low food inflation might have brought them some relief compared to five years ago when food inflation was at double-digit levels. However, any situation where food inflation is allowed to rise in order to give a boost to the non-food economy might end the perceived well-being of the poorer sections. Politically, this matters a lot. The current government has always taken credit for ensuring low inflation under its watch. To be sure, a prolonged slowdown is bound to hurt the poor as much as the rich in any economy.

This policy dilemma is not something which cannot be bypassed. The current CES numbers predate the implementation of the National Food Security Act, which radically increased the coverage under the Public Distribution System (PDS). This, if it is functioning well, would have made a large majority immune to inflation in cereal prices. If the PDS were to be expanded to cover non-cereal food items too, controlling food inflation at the cost of keeping the economy repressed would not be as a much of a political necessity as it is today.

We would have had greater clarity on these issues, had the NSSO released the latest findings of the CES, which was carried out in 2017-18.

AN ANALYSIS OF CONSUMPTION DATA FROM THE NATIONAL SAMPLE SURVEY OFFICE SUGGESTS THAT THERE IS SOME MERIT IN RECONSIDERING THE INFLATION-TARGETING FRAMEWORK IN INDIA