CPI

Okay, Let’s Get Subramanian Swamy’s Nonsense on Raghuram Rajan Out of the Way

ARTS RAJAN

Subramanian Swamy has gone after the Gandhi family over the last few years and been fairly successful at it. Now he seems to have moved on to a new target—the Reserve Bank of India(RBI) governor, Raghuram Rajan.

Swamy, who recently became a Rajya Sabha member, wrote a letter to the prime minister Narendra Modi, asking him to terminate the services of the RBI governor immediately or when his term ends in September, later this year.

As Swamy writes in the letter: “The reason why I recommend this is that I am shocked by the wilful and apparently deliberate attempt by Dr Rajan to wreck the Indian economy. For example the concept of containing inflation by rising interest rates is disastrous.”

Let’s take the point of Rajan raising interest rates turning out to be disastrous. When Rajan took over as the RBI governor, inflation was close to 10%. Interest rates offered on bank fixed deposits were lower than that. Hence, people were losing money once inflation was taken into account.

Due to this, money had moved into real estate as well as gold, as people looked for a “real” rate of return. In fact, when Rajan took over as RBI governor,
rupee was rapidly losing value against the dollar. One of the reasons was that there was a huge demand for dollars because Indians were buying gold to hedge against inflation. Rajan cracked down on this, and managed to stabilise the value of the rupee.

The stabilisation of the rupee was important because India imports 80% of the oil that it consumes. And when the rupee depreciates oil becomes expensive in rupee terms. This isn’t good for the government nor the overall economy.

Also, over the years high inflation has essentially ensured that the household financial savings as a proportion of the gross domestic product have been falling. Between 2005-2006 and 2007-2008, the average rate of household financial savings stood at 11.6% of the GDP. In 2009-2010, it rose to 12% of GDP. By 2011-2012, it had fallen to 7% of the GDP. The household financial savings in 2014-2015 stood at 7.5% of GDP.

Household financial savings is essentially a term used to refer to the money invested by individuals in fixed deposits, small savings schemes of India Post, mutual funds, shares, insurance, provident and pension funds, etc. A major part of household financial savings in India is held in the form of bank fixed deposits and post office small savings schemes.
In order to ensure that household financial savings go up, basically two things are needed—lower inflation as well as a real rate of return on financial savings that people make, in particular fixed deposits. Fixed deposits offer a real rate of return when the interest rate on the fixed deposit is higher than the inflation.

Since the beginning of 2015, after a very long time, the interest rates on fixed deposits have been in real territory. And this is a very important achievement for Rajan. The interest rates need to stay in real territory, if household financial savings need to go up, in the years to come.

In fact, it needs to be said here that Rajan recognises the fact that interest rates are not just about borrowers. They are also about savers as well. The savers include the young trying to save for the future of their children and the old trying to live a decent life in retirement. And savers need to be paid a reasonable rate of return on their savings as well. This is something that Rajan set right.

Swamy further said: “When the Wholesale Price Index (WPI) started to decline due to induced recession in the small and medium industry, he shifted the target from WPI to the Consumer Price Index (CPI) which has not however declined because of retail prices. On the contrary it has risen. Had Dr. Raghuram Rajan stuck to WPI interest rates would have been much lower today, and given huge relief to small and medium industries. Instead they are squeezed further and consequent increasing unemployment.”

It is important to understand here why the Rajan led RBI moved from following inflation as measured by the wholesale price index to inflation as measured by the consumer price index. When the RBI tracked inflation as measured by the wholesale price index, it took a very long time to raise interest rates, and by the time the high consumer price inflation had well and truly set in.

The high inflation then caused problems, as I have explained above. Let’s take the point about high interest rates hurting small and medium industries. Recent data shows that this is not true at all. Data for 2.37 lakh unlisted private firms was recently released by the RBI. This primarily includes small and medium enterprises, which Swamy feels are having a tough time.

This data clearly shows that these firms are doing much better than the big listed firms, over the last three years. Aarati Krishnan writing in The Hindu Business Line points out: “Unlisted firms managed far better sales growth in the last three years. They went from 13.3 per cent sales growth in FY13 to 8.7 per cent in FY14 before bouncing back to a healthy 12 per cent in 2014-15. In contrast, listed companies saw their sales growth dwindling from 9.1 per cent in FY13, to 4.7 per cent in FY14 and further to an abysmal 1.4 per cent by FY15.”

The same trend was seen when it comes to net profit as well. As Krishnan points out: “Their profits grew at 16 per cent, 23.6 per cent and 12.3 per cent in the last three years. Listed companies struggled with shrinking profits, their net profits falling by 2 per cent, 5.1 per cent and 0.7 per cent in the same three years.”

So what is Swamy really talking about here? And why is he misleading the prime minister Modi in particular and the nation in general?

Swamy further says: “Thus, in the last two years estimated NPA in public sector banks has doubled to Rs. 3-1/2 lakhs crores.”

What Swamy is basically saying is that the high interest rate regime initiated by the RBI led to small and medium enterprises defaulting on their loans and bad loans of public sector banks doubling. The first point that needs to be made here is that before Rajan took over as the governor of RBI, banks were not recognising their bad loans. He has pushed them to recognise their bad loans. Hence, the jump in bad loans has been primarily because of that.

What this means is that even before Rajan led RBI started raising interest rates, many corporates were not in a position to repay their loans. The banks were pretending all was well, when that wasn’t really the case. Rajan forced them to start recognising bad loans. All these huge losses that banks have suddenly started to report can’t have been created overnight. They are a result of banks not recognising these bad loans for a substantially long period of time. Hence, Swamy’s charge doesn’t hold true.

Also, defaults by mid and large corporates are a very important reason for public sector banks being in the mess that they are in. Crony capitalists close to the previous UPA regime are primarily responsible for this.

The last that I checked the RBI was a regulator of banks and did not give out any loans. So how can the RBI governor be held responsible for what are basically bad lending decisions by banks? How can the RBI governor be held responsible for banks not insisting on enough collateral for the loans that they gave out? And how can the RBI governor be held responsible for politicians forcing public sector banks to give loans to crony capitalists?

Swamy further said: “These actions of Dr. Rajan lead me to believe that he is acting more as a disrupter of the Indian economy [italics are mine] than the person who wants the Indian economy to improve.” I agree with the part of the statement which says that Rajan is acting as a disrupter of the Indian economy.

In fact, on many fronts, the Indian economy did need a disrupter. Rajan has forced banks to start recognising their bad loans instead of extending and pretending, as they were doing earlier. This has brought out the real situation that public sector banks are in.

Further, he has also empowered banks to go after defaulters. A few Indian promoters have started selling their assets in order to repay banks. This is something that hasn’t happened before.

Rajan has also initiated the formation of a monetary policy committee where monetary policy will be made by a committee. As of now, only the governor is responsible for it. A central bank operating through a monetary policy committee is the norm the world over. And by doing this, the governor is essentially diluting his powers.

Further, he has given small banks licenses and payment bank licenses as well, with the idea of expanding financial inclusion across the country. So, yes Rajan is a disrupter, who wants the Indian economy to improve.

Swamy also accused Rajan of being mentally not fully Indian. As he said: “Moreover he is in this country on a Green Card provided by the U.S. Government and therefore mentally not fully Indian. Otherwise why would he renew his Green Card as RBI Governor by making the mandatory annual visit to the U.S. to keep the Green Card current?”

Rajan still has an Indian passport. This after having lived in the United States for more than 25 years. How many Indians who have lived in the United States for 25 years still have an Indian passport?

And if Rajan wants to keep his green card active, what is wrong with that? He is a professional in his early 50s and still has his career to think about. He needs to think about his career beyond the RBI and if that means visiting the US once every year, then so be it.

Swamy finally asked for the termination of Rajan’s appointment as RBI governor. As he said: “I cannot see why someone appointed by the UPA Government who is apparently working against Indian economic interests should be kept in this post when we have so many nationalist minded experts available in this country for the RBI Governorship. I therefore urge you to terminate the appointment of Dr. Raghuram Rajan in the national interest.”

This is a very silly argument. Appointing Rajan as the RBI governor was one of the few correct things that the UPA government did in the second half of its second term. Why undo that?

And as far as Swamy is concerned, there are better ways of showing interest in the RBI governor’s job than this.

The column was originally published in Vivek Kaul’s Diary on May 19, 2016.

Raghuram Rajan won’t cut interest rates even in Hindi

ARTS RAJANAt a recent function, Raghuram Rajan, the governor of the Reserve Bank of India (RBI), spoke in Hindi. The joke going around in the social media after that was that even in Hindi, Dr Rajan refused to cut the repo rate. Repo rate is the interest rate at which the RBI lends to banks. Nevertheless, four pieces of data that came out last week, will increase the pressure on Rajan to cut the repo rate. These four pieces of data are as follows:

  1. Inflation as measured by the consumer price index fell to 5.52% in October 2014. It was at 6.46 % in September 2014 and 10.17% in October 2013. 

  2. Inflation as measured by wholesale price index fell to 1.77%. It was at 2.38 % in September 2014 and 7.24% in October 2013. 

  3. The index of industrial production, which is a measure of the industrial activity within the country, grew by 2.5% in September 2014, in comparison to September 2013. The IIP for August 2014 was only 0.4% higher in comparison to August 2013. Interestingly, some economists believe that this marginal recovery in the IIP will not hold for October 2014. The reason for this lies in the fact that indicators of industrial activity like car sales, bank loan growth etc., have slowed down in October 2014. 

  4. The bank loan growth for a period of one year ending October 31, 2014, stood at 11.2%. This had stood at 16.4%, for the period of one year ending November 1, 2013. The loan growth year to date stands at 4.6%. It was at 7.6% last year.

These four data points have got the Delhi based economic experts and industry lobbyists brushing up their economic theory again. “It is time that the RBI started to cut interest rates,” we are being told. Chandrajit Banerjee, the director general of the Confederation of Indian Industries, a business lobby said “This provides sufficient room to the RBI to review its prolonged pause in policy rates and move towards policy easing in its forthcoming monetary policy especially as investment and consumption demand are yet to show visible signs of a pick-up.” This was a sentiment echoed by A Didar Singh as well. Singh is the secretary general of Federation of Indian Chambers of Commerce and Industry (FICCI), which is another industry lobby. As he put it “The inflationary expectations are fairly tamed and we see no immediate upside risks with regard to prices. Given that, it is important to reiterate that demand remains subdued. The consumer durables segment reported negative growth for the fourth consecutive month in September. It is imperative that all levers are used to pep up demand.” The idea here is simple. If the RBI cuts the repo rate, banks will cut the interest rates they charge on their loans as well. If that were to happen, people would borrow and spend more, and businesses would borrow and invest more. And this will lead to faster economic growth. Economics 101. QED. Banerjee and Singh are not the only ones asking for an interest rate cut. Sometime back industrialist Anand Mahindra had said that “It might be time for the RBI to think of a rate cut…The need of the hour has changed and its time to start to look to support growth.” Sunil Mittal, chief of Bharti Airtel, also suggested the same when he told CNBC TV 18 that the finance minister Arun Jaitley “had spoken for the nation,” when had asked for an interest rate cut. In an interview to The Times of India in late October Jaitley had said “Currently, interest rates are a disincentive. Now that inflation seems to be stabilizing somewhat, the time seems to have come to moderate the interest rates.” While all this sounds good in theory, things are not as simple as the businessmen and the politicians are making it out to be. It is worth recounting here what Rajan had said in a speech in February 2014: “But what about industrialists who tell us to cut rates? I have yet to meet an industrialist who does not want lower rates, whatever the level of rates.” And what about the politicians? Alan Greenspan, the former chairman of the Federal Reserve of the United States, recounts in his book The Map and the Territory that in his more than 18 years as the Chairman of the Federal Reserve, he did not receive a single request from the US Congress urging the Fed to tighten money supply and thus not run an easy money policy. In simple English, what Greenspan means is that the American politicians always wanted lower interest rates. The Indians ones aren’t much different on that front. Nonetheless, the question is will lower interest rates help in reviving consumption and investment? Let’s tackle the issues one by one. Let’s say an individual wants to buy a car. He borrows Rs 4 lakh to be repaid over a period of five years at a rate of interest of 10.5%. The EMI on this works out to Rs 8,598. Let’s say the RBI cuts the interest rate and as a result the interest rate on the car loan falls to 10%. The EMI now works out to Rs 8,499 or around Rs 100 lower. Now will an individual go out and buy a car because the EMI is Rs 100 lower? Even if interest rates fall by 200 basis points (one basis point is one hundredth of a percentage) to 8.5%, the EMI will come down by only around Rs 400. For two wheeler and consumer durables loans, the differences are even smaller. Hence, suggesting that lower interest rates lead to higher consumption isn’t really correct. The real estate experts think that cutting interest rates will help revive the sector. The basic problem with the real estate sector is that prices have gone totally out of whack and a cut in interest rates is not going to have any significant impact. What about corporate investment? As Rajan had asked in his speech “Will a lower policy interest rate today give him more incentive to invest? We at the RBI think not…We don’t believe the primary factor holding back investment today is high interest rates.” So what is holding back investment? The answers are provided in a recent report titled “Will a rate cut spur investments?Not really“, brought out by Crisil Research. As the report points out “Investment growth, particularly private corporate investment, plummeted in the fiscals 2013 and 2014, despite low real interest rates. During this time, the policy rate in real terms – repo rate minus retail inflation – has been negative, and real lending rates averaged 2.4%. This is significantly lower than the 7.4% seen in the pre-crisis years (2004-2008). Yet investment growth dropped to 0.3%, down from an average 16.2% seen in the pre-crisis years.” The accompanying chart makes for an interesting read. 

After 6 years, real repro rate (adjusted for CPI inflation) turns positive

Source: RBI, Central Statistical Office, CRISIL Research Note: Nominal repo rate at the fiscal year-end minus average CPI inflaction , F= Forecast

As Crisil Research points out “During fiscals 2013 and 2014, when investment growth slumped to 0.3% per year, the real repo rate was still minus 2.1%, while the real lending rate was only +2.8%. Only in June 2014, for the first time in six years, did the real repo rate turned mildly positive.” So companies were borrowing and investing at higher “real” interest rates earlier but they are not doing that now. Why is that the case? This is primarily because the expected rate of return on investments has fallen “because of high policy uncertainty, slowing domestic and external demand, and rising input costs driven by persistently elevated inflation.” “The rate of return on investments – as proxied by return on assets (RoA) of around 10,000 non-financial companies as per CMIE Prowess database – have fallen sharply to 2.8% in fiscal 2013 and 2014 from 5.9% in the pre-crisis years,” Crisil Research points out. Moral of the story: Corporates invest when it is profitable to invest, and not simply because interest rates are low. Indeed, the other factors that are likely to revive investment are in the hands of the government and not RBI. Hence, a cut in interest rates is neither going to revive consumer demand nor corporate investments. Having said that, high food inflation has been a big factor behind high inflation. And the RBI really cannot control that. Also, food inflation has come down considerably in the recent past. So why not just cut interest rates? Rajan explained it very well in his February speech where he said “They say the real problem is food inflation, how do you expect to bring it down through the policy rate? The simple answer to such critics is that core CPI inflation, which excludes food and energy, has also been very high, reflecting the high inflation in services. Bringing that down is centrally within the RBI’s ambit.” Further, food prices might start rising again. The government has forecast that the output of kharif crops will be much lower than last year and this might start pushing food prices upwards all over again. Also, recent data showsthat vegetable and cereal prices have started rising again because of the delayed monsoon. To conclude, despite falling inflation, the inflationary expectations (or the expectations that consumers have of what future inflation is likely to be) are on the higher side. As per the Reserve Bank of India’s Inflation Expectations Survey of Households: September – 2014, the inflationary expectations over the next three months and one year are at 14.6 percent and 16 percent. In March 2014, the numbers were at 12.9 percent and 15.3 percent. Hence, inflationary expectations have risen since the beginning of this financial year. And for inflationary expectations to come down, low inflation needs to stay for a considerable period of time. As Rajan said “A more important source of our influence today, therefore, is expectations. If people believe we are serious about inflation, and their expectations of inflation start coming down, inflation will also come down…Sooner or later, the public always understands what the central bank is doing, whether for the good or for the bad. And if the public starts expecting that inflation will stay low, the central bank can cut interest rates significantly, thus encouraging demand and growth.” If inflationary expectations are controlled only then will consumer demand revive and that in turn, will lead to revival of corporate investments as well. Given this, it would be surprising to see Rajan start cutting the repo rate any time soon. The article originally appeared on www.equitymaster.com on Nov 17, 2014

Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He has just finished writing a trilogy on the history of money and the financial crisis. The series is titled Easy Money. His writing has also appeared in The Times of India, Business Standard, Business Today, The Hindu and The Hindu Business Line. 

Lessons for govt from a Mumbai taxi driver: Why inflation is killing growth

KONICA MINOLTA DIGITAL CAMERA

Vivek Kaul

Sometimes it takes a small nudge to start doing what might later seem obvious. A few months back I happened to read Nicholas Epley’s Mindwise—How we understand what others Think, Believe, Feel and Want. Epley is a professor of behavioural science at the University of Chicago’s Booth School of Business.
In this book Epley writes that “isolating activities like commuting are some of the least pleasant of any day.” “Not only is isolation unpleasant, it is bad for your health as well.” Hence, he goes on to suggest that it always makes sense to communicate with your fellow commuters or in case of taxicabs, the drivers.
“In fact, the positive effect of talking to one’s taxi driver is particularly large. Perhaps because taxi drivers come from interesting and varied backgrounds, they seem to make especially pleasant conversational partners, at least for the length of your ride…The stories I get are fascinating, the conversations are almost always interesting, and my experience is consistently better than if I had simply stared out of the window instead…Your ability to engage with minds of others is one of your brain’s greatest abilities. You’ll be happier if you actually use it,” writes Epley.
After reading this book I have “nudged” myself in the direction of trying to have a conversation with the taxi-driver, every time I use a taxicab. Late last night I was coming back home after having dinner and starting talking to the driver. Over the last few weeks the conversation usually starts around the recent increase of the minimum cab fare in Mumbai from Rs 19 to Rs 21. And then it goes off in different directions.
Yesterday night was not different from the usual except for the way the driver reacted. He was of the opinion that the decision to increase the minimum fare from Rs 19 to Rs 21 was a stupid one and that the taxi union hadn’t been doing its job properly. The response intrigued me, given that this was the first time I came across someone who did not seem to be happy at the prospect of a higher income in these inflationary times.
I asked him to explain in detail what he meant. “Main to kehta hoon minimum pandrah rupaiye kar dena chahiye, (I think the minimum taxi fare should be reduced to Rs 15),” he immediately responded. This intrigued me further. “Log taxi le nahi rahe hain. Kaafi samay khaali baithe rehna padta hai (People are not taking taxis and for long periods of time I am just sitting idle),” he continued.
And then he went on to explain that at a lower fare he would get more customers, wouldn’t have to sit idle for long periods of time during the day and would in the process end up making more money, even though the amount of money he would make per kilometre would be lower. Sometimes wisdom strikes you at the most unlikely of places. Last night I had that kind of a experience.
High inflation has been the bane of this country over the last five years. And that has hit all kinds of people including the taxi-driver I was talking to last night. When fares are raised, it means a higher price for hiring a cab for the end consumer. And he or she is not always ready to pay for that. Hence, an increase in taxi fare, which is basically inflation for the end consumer, leads to loss of business for the taxi-driver.
The way it works for the taxi-driver at the individual level, also works for the society as whole at a much broader level. As prices rise, people cut down on the consumption of non-essentials. Due to high inflation people have had to spend more money on meeting daily expenditure. Food inflation in particular has been greater than 10% over the last few years, and has only recently started to come down a little.
Given this, people have been postponing all other expenditure and that has had an impact on economic growth. Anyone, with a basic understanding of economics knows that one man’s spending is another man’s income, at the end of the day. When consumers are going slow on purchasing goods, it makes no sense for businesses to manufacture them.
This is reflected in the index of industrial production, which is a measure of the industrial activity within the country. Numbers released yesterday by the Central Statistics Office showed that for the month of July 2014, the index of industrial production grew by a minuscule 0.5% in comparison to July 2013. This was largely on account of a slowdown in manufacturing, which forms nearly three-fourths of the index of industrial production. It contracted by -1%. Many sectors within manufacturing like tobacco, apparels, paper and paper products, communication, publishing, furniture etc, contracted majorly.
This is worrying given that the expansion of the manufacturing sector remains India’s best bet to create jobs at a fast pace, for its semi-skilled workforce. And manufacturing cannot be turned around unless inflation is brought under control, so that consumer demand revives, and in turn encourages businesses to increase production of goods. Interestingly, August 2014 saw a major revival in car sales with sales going up by more than 15%.
Along with the index of industrial production, the Central Statistics Office also released the consumer price inflation number, yesterday. Inflation in August 2014 stood at 7.8%. This was a tad lower in comparison to the inflation in July 2014, which was at 7.96%. The inflation in July 2013 had stood at 9.52%.
While this is clearly good news, the worrying bit is that food inflation continues to remain high at 9.42%. In July 2014 the number had stood at 9.36%. In August last year, the number had stood at 11.11%. “In the case of food articles, price pressures were seen building up in pulses, condiments & spices and milk & milk products. Inflation in each of these categories has been rising for the last 3 months,” Crisil Research pointed out in a research note yesterday.
As I have often pointed out in the past, half of the expenditure of an average household in India is on food. In case of the poor it is 60%. If consumer demand is to be revived then food inflation needs to be brought under control.
Analysts believe that consumer price inflation will continue to fall in the months to come. A major reason for this is the fall in global oil prices. “A significant decline in petrol prices (Rs 5.4 per litre since July in Mumbai) due to lower crude oil prices globally, is also likely to have contributed to the downward price pressures in transport & communication. We expect this to continue going forward as no further hike in diesel prices is expected as long as crude oil prices stay at current levels,” Crisil Research points out.
On the flip side, a weak monsoon has led to the build up of “inflationary expectations” (or the expectations that consumers have of what future inflation is likely to be). And this could play a spoiler in reviving consumer demand.
In the long run, other than bringing down inflation the government needs to carry out structural reforms in order to revive Indian manufacturing. As Crisil Research points out “Incremental policy measures and bureaucratic improvements that the new government has taken in its first 100 days to improve the ease of doing business, has had a positive impact on business sentiments. However, it will take some time for these to translate into growth. While these are critical to lift growth in the short-term, the government needs to move forward with structural policy reforms such as implementation of GST (Goods and services tax), easing labour laws, rationalisation of fiscal subsidies, and amendment of land acquisition norms, to maintain the growth momentum beyond this year.” And that is easier said than done.
The article originally appeared on www.FirstBiz.com on Sep 13, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Will Rajan do a Volcker before 2014 Lok Sabha elections?

 ARTS RAJANVivek Kaul
People who follow the Reserve Bank of India(RBI) governor Raghuram Rajan were expecting him to raise the repo rate by 25 basis points(one basis point is one hundredth of a percentage) in the mid quarter monetary policy review announced on December 18, 2013. Repo rate is the rate at which RBI lends to banks.
But that did not happen. This led one journalist attending the press conference after the policy announcement, to quip “We were expecting a Volcker, we got a Yellen.” To this, governor Rajan replied “Why a Volcker or a Yellen, how about a Rajan?” (As reported in the Business Standard).
Rajan took over as the 23rd governor of the RBI on September 4, 2013. Since then he has often been compared to the former Federal Reserve chairman Paul Volcker.
Volcker took over as the chairman of the Federal Reserve of United States in August 1979. This was an era when the United States had double digit inflation.
Interestingly, when Arthur Burns retired as the Chairman of the Federal Reserve in 1978, the inflation was at 9%. Jimmy Carter, the President of the United States, chose G William Miller, a lawyer from Oklahoma, as the chairman of the Federal Reserve.
Miller had no background in economics. As Neil Irwin writes in The Alchemists – Inside the Secret World of Central Bankers “Most significantly, Miller, fearful of a recession, refused to tighten the money supply to fight inflation. By the summer of 1979, with inflation at 10 percent, Carter had had enough. He “promoted” Miller to treasury secretary as a part of the cabinet shake-up, a job with less concrete authority. That left him with a vacancy in the Fed chairmanship.”
Carter picked up Paul Volcker as Miller’s replacement. Volcker at that point of time was the President of the Federal Reserve Bank of New York. Volcker had been a civil servant under four American presidents. “In his meeting with the president before the appointment, Volcker told Carter he was inclined to tighten the money supply to fight inflation. That’s what Carter was looking for – but he almost certainly didn’t understand just what he was getting,” writes Irwin.
In the year that Volcker took over consumer prices rose by 13%. The only way out of this high inflation was to raise interest rates and raise them rapidly. The trouble was that Jimmy Carter was fighting for a re-election in November 1980.
As Irwin writes “On an air force jet en route to an International Monetary Fund conference in Belgrade, Volcker explained his plans to Carter’s economic advisers. They didn’t like them one bit. Sure, Carter wanted lower inflation. But higher interest rates affect the economy with a lag of many months. There was barely a year to go until the president would be running for reelection, which meant that just as their boss was asking voters for another term, unemployment would be sky-rocketing due to the new Volcker policy.”
Volcker was not going to sit around doing nothing and came out all guns blazing to kill inflation which by March 1980 had touched a high of 15%. He kept increasing increasing rates, till they had touched 20% by January 1981. This had an impact on inflation and it fell to below 10% in May and June 1981. 
The prime lending rate or the rate at which banks lend to their best customers, had been greater than 20% for most of 1981. Increasing interest rates did have a negative impact on economic growth and led to a recession. In 1982, the unemployment rate crossed 10%, the highest it had been since 1940 and nearly 12 million Americans lost their jobs.
During the course of the same year, nearly 66,000 companies filed for bankruptcy, the highest since the Great Depression. And between 1981-83,, the economy lost $570 billion of output. While all this was happening, Jimmy Carter also lost the 1980 presidential elections to Ronald Reagan.
India and Rajan are in a similar situation right now. The consumer price inflation(CPI) for the month of November 2013 was at 11.24%. In comparison the number was at 10.17% in October 2013. At the same time Lok Sabha elections are due next year.
In this scenario will Rajan jack up the repo rate to control inflation? When a central bank raises the interest rate the idea is to make borrowing expensive for everyone. At higher interest rates people are likely to borrow less than they were in the past. Also, people are likely to save more money. This ensures that a lesser amount of money chases goods and services, and that in turn brings inflation down.
At higher interest rates, borrowing becomes expensive for the government as well. This might force the government to cut down on its expenses. When a government cuts down on its expenses, a lower amount of money enters the economy, and that also helps in controlling inflation. But that is just one part of the argument.
One school of thought goes that there is not much the RBI can do about inflation by increasing interest rates. Leading this school is finance minister P Chidambaram. As he said in late November “Consumer inflation in India is entrenched due to high food and fuel prices and monetary policy has little impact in curbing these prices…There are no quick fixes for inflation, will take some time to fix it,” he said.
This logic is borne out to some extent if one looks at the inflation numbers in a little more detail. The food inflation as per wholesale price index(WPI) was at 19.93% in November 2013. Within it, onion prices rose by 190.3% and vegetable prices rose by 95.3%. The food inflation as per the consumer price index(CPI) stood at 14.72% in November 2013. Within food inflation, vegetable prices rose by 61.6% and fruit prices rose by 15%, in comparison to November 2012.
Hence, a large part of inflation is being driven by food inflation. As the RBI said in the Mid-Quarter Monetary Policy Review: December 2013 statement released on December 18, 2013, “Retail inflation measured by the consumer price index (CPI) has risen unrelentingly through the year so far, pushed up by the unseasonal upturn in vegetable price.”
A major reason behind the Rajan led RBI not raising the repo rate was the fact that they expect vegetable prices to fall. “Vegetable prices seem to be adjusting downwards sharply in certain areas,” it said in the monetary policy review statement. Taimur Baig and Kaushik Das of Deutsche Bank Research in a note dated December 18, 2013, said “vegetable prices, key driver of inflation in recent months, have started falling in the last couple of weeks (daily prices of 10 food items tracked by us are down by about 7% month on month(mom) on an average in the first fortnight of December).”
If vegetable prices in particular and food prices in general do come down then both the consumer price and wholesale price inflation are likely to fall. If we look at the RBI’s decision to not raise the repo rate from this point of view, it looks perfectly fine.
But there is another important data point that one needs to take a look at. And that is core retail inflation. If one excludes food and fuel constituents that make up for around 60% of the consumer price index, the core retail inflation was at 8% in November 2013. This needs to be controlled to rein in inflationary expectations. As the monetary policy review statement of the RBI points out “High inflation…risks entrenching inflation expectations at unacceptably elevated levels, posing a threat to growth and financial stability.”
According to a recent survey of inflationary expectations carried out by the RBI, Indian households expect consumer prices to rise by 13% in 2014. Th rate of inflation that people(individuals, businesses, investors) think will prevail in the future is referred to as inflationary expectation. Inflationary expectations can be reined in to some extent by raising interest rates. As Baig and Das said in a note dated December 16, “RBI would still want to maintain a hawkish stance to ensure that inflation expectations (which is firmly in double digit territory as per recent surveys) do not rise further.”
The trouble here is that higher interest rates will dampen consumer expenditure further. At higher interest rates people are less likely to borrow and spend. The businesses are less likely to expand. This is reflected in the private final consumption expenditure(PFCE) number which is a part of the GDP number measured from the expenditure point of view. The PFCE for the period between July and September 2013 grew by just 2.2%(at 2004-2005 prices) from last year. Between July and September 2012 it had grown by 3.5%. The PFCE currently forms around 59.8% of the GDP when measured from the expenditure side.
The lack of consumer demand is also reflected in the index of industrial production(IIP), a measure of industrial activity. For October 2013, IIP fell by 1.8% in comparison to the same period last year. If people are not buying as many things as they used to, there is no point in businesses producing them. It is also reflected in manufactured products inflation, which forms around 65% of WPI. It stood at 2.64% in November 2013.
When the demand is not going up, businesses are not in a position to increase prices. And that is reflected in the manufacturing products inflation of just 2.64%. It was at 5.41% in November 2012.
Given this, if the Rajan led RBI were to keep raising the repo rate to bring down inflationary expectations, it would kill consumer demand further. The Congress led UPA government won’t want anything like this to happen in the months to come. They have already messed up with the economy enough.
Hence, Rajan and the RBI would have to make this tricky decision. If the keep raising the repo rate, chances are they might be able to rein in inflationary expectations and hence inflation, in the time to come. Nevertheless, if they keep doing that the chances of the Congress led UPA in the Lok Sabha elections will go down further.
To conclude, when Arthur Burns was appointed as the chairman of the Federal Reserve on January 30, 1970, president Richard Nixon had remarked,“I respect his independence. However, I hope that independently he will conclude that my views are the ones that should be followed”. Burns had not disappointed Nixon and started running an easy money policy before the 1972 presidential election, which Nixon eventually won.
Raghuram Rajan needs to decide, whether he wants to go against the government of the day and do what Volcker did, or fall in line and help the government win the next election, like Burns did. Its a tricky choice.
 The article originally appeared on www.firstpost.com on December 20, 2013 
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Why inflation-fighter Raghuram Rajan did not raise the repo rate

ARTS RAJANVivek Kaul 
Raghuram Rajan, the governor of the Reserve Bank of India (RBI) surprised everybody today, by choosing to not raise the repo rate. The repo rate will continue to be at 7.75%. Repo rate is the rate at which the RBI lends to banks.
Economists had been predicting that Rajan will raise the repo rate in order to rein in inflation. The consumer price inflation(CPI) for the month of November 2013 was at 11.24%. In comparison the number was at 10.17% in October 2013. The wholesale price inflation(WPI) number for November 2013 came in at 7.52%. In comparison the number was at 7% in October 2013.
As Taimur Baig and Kaushik Das of Deutsche Bank Research wrote in a note dated December 16, 2013 said “The upside surprise in both CPI and WPI inflation for November leaves no option for RBI but to hike the policy rate(i.e. the repo rate) by 25basis points in Wednesday’s monetary policy review, in our view.”
Along similar lines Sonal Varma, India economist at Nomura, told CNBC.com that she expected the RBI to increase the repo rate by 25 basis points(one basis point is one hundredth of a percentage). But Rajan has chosen to stay put and not raise the repo rate.
Why is that the case? The answer lies in looking at the inflation numbers in a little more detail. The consumer price inflation is primarily being driven by food inflation. Food (along with beverages and tobacco) accounts for nearly half of the index. Food inflation in November 2013 as per the CPI stood at 14.72%. Within food inflation, vegetable prices rose by 61.6% and fruit prices rose by 15%, in comparison to November 2012.
So what this tells us very clearly is that consumer price inflation is being driven primarily by food inflation. In fact, this is something that the WPI data also clearly shows. The food inflation as per WPI was at 19.93%. Within it, onion prices rose by 190.3% and vegetable prices rose by 95.3%.
The RBI expects vegetable prices to fall. Baig and Das in a note dated December 18, 2013, said “vegetable prices, key driver of inflation in recent months, have started falling in the last couple of weeks (daily prices of 10 food items tracked by us are down by about 7% month on month(mom) on an average in the first fortnight of December).”
In case of WPI, food articles have a much lower weightage of around 14.33%. The other big contributor to WPI was fuel and power, in which case the inflation was at 11.08%. This is primarily on account of diesel and cooking gas prices being raised regularly in the recent past.
So inflation is primarily on account of two counts: food and fuel prices going up. The Reserve Bank of India cannot do anything about this. And given that raising the repo rate would have had a limited impact on high inflation.
In fact, if one looks at the WPI data a little more carefully, there is a clear case of the economy slowing down. Manufactured products form a little under 65% of the wholesale price inflation index. The inflation in case of manufactured products stood at 2.64% in November 2013.
When people are spending more and more money on buying food. They are likely to be left with less money to buy everything else. In this scenario they are likely to cut down on their non food expenditure.
And this has an impact on businesses. When the demand is not going up, businesses are not in a position to increase prices. And that is reflected in the manufacturing products inflation of just 2.64%. It was at 5.41% in November 2012.
Interestingly, the high cost of food should translate into the cost of labour going up. At the same time, energy prices are also going up. This is reflected in the fuel and power inflation of 11.08%. But businesses have not been able to pass through these increases in the cost of their inputs, by raising the price of their final products. This is primarily because of the lack of consumer demand.
The lack of consumer demand is also reflected in the index of industrial production(IIP), a measure of industrial activity. For October 2013, IIP fell by 1.8% in comparison to the same period last year. If people are not buying as many things as they used to, there is no point in businesses producing them.
In this scenario, raising interest rates would mean that people looking to borrow and spend money to buy goods, will have to pay higher EMIs. Businesses looking to borrow money and expand will also have to pay more. And this turn impacts economic growth. As the RBI’s statement today put it “The weakness in industrial activity persisting into Q3, still lacklustre lead indicators of services and subdued domestic consumption demand suggest continuing headwinds to growth.”
In this scenario the Rajan led RBI decided to keep the repo rate constant. What is interesting is that the RBI’s statement has suggested that it might raise the repo rate if the food inflation does not fall as it is expected to. “If the expected softening of food inflation does not materialise and translate into a significant reduction in headline inflation in the next round of data releases, or if inflation excluding food and fuel does not fall, the Reserve Bank will act, including on off-policy dates if warranted,” the statement said.
Effectively, the RBI has bought some time. “The RBI has effectively given itself a one-month window to see if inflation actually eases in December to decide on future monetary policy action,” wrote Baig and Das of Deutsche. 
In fact, Raghuram Rajan’s decision not to raise the repo rate has been seen as a surprise primarily because he has made several comments in the public saying that inflation was running higher than the comfort level. Also, Rajan is seen as an inflation fighter, and by not raising the repo rate, he has put that image at risk.
As Robert Prior-Wandesforde, director of Asian economics research at Credit Suisse, recently wrote “The data pose the now familiar dilemma for the central bank. While the direct effect of interest rate hikes on inflation is debatable, particularly when food prices are such an important driver, we very much doubt Dr. Rajan can be seen to be sitting on his hands at this stage …”To do so, would be take risks with his inflation fighting credentials,” he added.
It is hard to believe that Rajan will these credentials at risk. And given that we might just see a repo rate hike early in the new year.
The article originally appeared on www.firstpost.com on December 18, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)