There is a widely and strongly held view that the RBI has been is keeping its Repo rate, i.e. the rate at which it lends to banks, too high. But the RBI can point to the latest data, released on 13 June, which shows that the Consumer Price Index (CPI) is up by 5.76%, and that the Consumer Food Price Index (CFPI) is up by 7.55%, year-on-year. There seems to be a disconnect between the high consumer inflation and the liquidity shortage being felt. The problem, in our view, is that the monetary policy, which impacts the entire economy, is being tailored for the CPI, which is based on a limited basket relevant to the consumer. Yes, a tight monetary policy will eventually tame all inflation including consumer inflation, but monetary policy should be based on what’s happening in the economy as a whole.
A better indicator of inflation should take into account the entire value added in the economy—all the goods and services, weighted as per their actual share. This purpose can be served by the “GVA Deflator”. It is a multiplier, based on the entire value added, that tells us how much higher current prices are as compared to prices in a fixed base year. [GVA stands for Gross Value Added, and is similar to GDP, but excludes subsidies and taxes.] Here are the quarterly Deflators for the past two years, computed from data released by the Central Statistics Office (see chart).
From this data, the true annual inflation, between Q4 2014-15 and Q4 2015-16, was just 1.02%. Furthermore, between Q3 and Q4 of 2015-16, the economy was deflating at an annual rate of 10%, which is very severe.
Thus, despite consumer inflation being at 5.76% and food inflation at 7.55%, the economy as a whole is being starved of liquidity, and may be in deflation. Persistent deflation can lead to a “deflationary spiral”, a vicious cycle wherein price deflation leads to hoarding of cash, which in turn puts further pressure on prices, and so on, until the entire economy stalls.
An index based on a limited basket, such as the CPI or the CFPI will necessarily give a limited view. A tight monetary policy, being justified in the name of the consumer, will end up making the consumer worse off, if it sinks the entire economy. This is like curing a fever by killing the patient. CPI-inflation is not a “nail” which can be dealt with by the “hammer” of monetary policy. Using the RBI interest rate as a tool to keep consumer inflation under control appears to be a fundamentally unsound idea. It is not that we do not care about the consumer. But the right way to deal with consumer inflation is by supply side measures, in sectors like irrigation and transportation, not by deflating the entire economy through monetary policy.
Does that mean that the RBI should cut its repo rate? Won’t that impact savers? We do want a high rate of return for savers, but we also want to turbo-charge economic growth by ensuring ample investment in priority sectors like irrigation and transportation. These are sectors which have historically been starved of investment. Moreover, alleviating bottlenecks in these sectors is what is needed to cure consumer inflation.
We are suggesting that a good return for savers does not necessarily contradict the need for high growth. There are better ways of conducting monetary policy than lending to banks at the repo rate. Let’s elaborate. There is another tool in the RBI’s toolbox for injecting liquidity—investing directly into the economy, a practice also known as “Quantitative Easing” (QE). We are suggesting that a significant portion of the RBI’s lending be dedicated to buying and holding long term government bonds, with some consequent decrease in lending to banks. The government should then use these funds to steer investment into priority sectors. The government does not have to fund the entire investments by itself—a subsidy to ensure zero or low interest rates will suffice. Road Transport Minister Nitin Gadkari has shown the way forward, by securitising toll income he has ensured plenty of funding for highways, even without any interest subsidy. There is no reason why the same securitisation strategy cannot be used for other sectors like irrigation, rail freight corridors and rural broadband. For example, farmers will be more than willing to pay for a reliable supply of water, delivered to their farms through pipes. Irrigation is the bottleneck that is limiting agricultural productivity. Asking farmers to pay for it will also incentivise them to use the most efficient methods, like drip irrigation.
Let’s look at what amounts could be made available. To keep the real inflation at a moderate level of say 4%, the money supply needs to grow at 4% plus the rate of growth of the economy (about 8%), i.e. at about 12%. This implies that the cash in the economy (i.e. “Reserve Money” in the RBI’s terminology) can increase by about Rs 2.6 lakh crore this year. If this Rs 2.6 lakh crore in new money is dedicated for the purpose of interest subsidy in priority sectors, Rs 26 lakh crore in zero or low interest funding can be secured, assuming an interest subsidy of 10%. This amounts to US $400 billion in zero or low interest funding for priority sector projects, which is a big amount even by global standards. There will be plenty of long term investors, both domestic and foreign, who would be happy to buy infrastructure bonds yielding 10%. Such investment could go a long way towards making the economy more productive, and taming consumer inflation. These amounts could be made even higher, if RBI were to allocate a larger portion of its portfolio to this program.
A consequence of this QE programme is that banks will have to raise a bigger proportion of their funds from savers, rather than from the RBI. This will lead to a higher rate of return for savers. Savers will also have the option of investing in the above infrastructure bonds. Furthermore, this programme will charge the economy by ensuring ample zero interest or low interest funding for priority sectors, and also address the root causes of consumer inflation, by creating infrastructure assets.
We would like to stress this QE programme need not be constrained by any rigid limit on the fiscal deficit. Government bonds held by the RBI are effectively interest free because the interest income of the RBI is in any case given to the government for its use. Other than the need to keep inflation under control, there is no limit to the amount the government can borrow from the RBI. If the borrowed amount is invested in productive assets, the increase in money supply will be accompanied by an increase in output, and will not cause inflation.
Recent QE programmes in the West have been criticised on the ground that they were used only to bail out cronies. The questions of who should get their hands on any monetary stimulus, and how this stimulus should be used, are indeed crucial. In our proposed programme, it is the starved priority sectors of the economy which will benefit. Needless to say, clear policies and a high degree of transparency will be required to ensure that stimulus funds are not diverted.
We conclude by remarking that programmes like what we have proposed here have, in recent times, been getting serious consideration from top economists. Examples are the debate in the UK on the “People’s QE” proposed by the Labour Party, and the “Money-Financed Fiscal Program” proposed by ex-US Fed Chairman Ben Bernanke.
Sameer Jalnapurkar is a scientist based in Pune, whose interests include Machine Learning, Knowledge Management Systems, Economics and Organic Agriculture. He can be contacted at email@example.com