Paul Volcker

Rail hike: India needs a bitter pill and Modi must not fall prey to ‘rollback’ culture

 

narendra_modiThe Narendra Modi government has come in for a lot of criticism for raising the railway fares. The criticism has been particularly acute in Mumbai, where the prices of suburban railway season tickets have doubled and in some cases even trebled. And this surely can’t mean acche din for the average Mumbaikar who travels by local trains daily and had voted overwhelmingly in the Lok Sabha elections for the BJP-Shiv Sena alliance.
Now there is talk about the government reconsidering the decision to increase railway season ticket prices. “The Railway Minister has assured us that the monthly season ticket decision will be reconsidered and a decision taken within 2-3 days,” said BJP MP Kirit Somaya after meeting the railway minister Sadanand Gowda today (i.e. June 24, 2014). This might very well turn out to be the case given that assembly elections are scheduled in Maharashtra later this year.
The Modi government will have to take a spate of unpopular decisions over the next few months, if it hopes to do something about the stagnating economic environment. These decisions might include passing on the increase in the price of oil to the end consumers. The price of the Indian basket of crude oil stood at $111.86 per barrel on June 20, 2014. It had averaged at $106.72 per barrel between May 29 and June 11, 2014.
The price of oil has gone up rapidly in June 2014 because of a threat of a war in Iraq. India imports nearly four fifth of the oil it consumes. The government will have to allow the oil marketing companies to pass on this increase in price to the end consumers. If it does not do that then it will have to compensate the oil marketing companies for the “extra” under-recoveries they face on the sale of diesel, cooking gas and kerosene. This would lead to an increase in government expenditure and hence, the fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends. The government is already precariously placed on the fiscal deficit front. The move to allow the oil marketing companies to increase prices is unlikely to go down well with the middle class.
The government will also have to make sure that it does not increase the minimum support price of rice and wheat at the same rate as the Congress led UPA government had done in the past. This had been a major reason in fuelling food inflation. So, if the government is serious about controlling food inflation this is a step that it will have to take. This move is unlikely to go down well with farmers.
Over and above this, the government will have to go aggressive on selling stakes it holds in public sector companies. This will help the government in controlling the fiscal deficit. Any attempts to sell stakes in the companies it owns is unlikely to go down well with the trade unions and given that they are likely to protest.
The broader point is that various steps that the government is likely to take over the next few months, will be fairly unpopular in nature. And given this there will be pressure on it to “rollback” these moves. In fact, as has been in the case of the railway fare hike, the pressure to “rollback” will come not only from the opposition parties, but also from within the BJP. Nevertheless, these steps are required if the economic environment is to brought back into some shape.
Given this, the government can take some inspiration from Paul Volcker. Volcker was the Chairman of the Federal Reserve of the United States, the American central bank, between 1979 and 1987. When Volcker assumed office in August 1979, things were looking bad for the United States on the inflation front. The rate of inflation was at 12 percent.In fact, inflation had steadily been going up over the years. Between 1964 and 1968, inflation had averaged 2.6 percent per year. This had almost doubled to five percent over the next four years, that is, 1969 to 1973. And it had increased to eight percent, between 1973 and 1978. In the first nine months of 1979, it had averaged at 10.75 percent. Such high inflation during a period of peace had not been experienced before. 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 percent. He kept increasing the interest rate till it had touched 20 percent by January 1981. This had an impact on the inflation, and it fell to below 10 percent 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 percent for most of 1981Increasing interest rates did have a negative impact on economic growth and led to a recession. In 1982, the unemployment rate crossed 10 percent, 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 and 1983 the economy lost $570 billion of output.
Of course, all this made Volcker a very unpopular man. As Neil Irwin writes in The Alchemist—Inside the Secret World of Central Bankers “Automakers were…livid: High interest rates meant that consumers couldn’t afford to buy cars…They [i.e. the automakers] mailed Volcker keys to unsold vehicles. But farmers may have had it worst of all. During the late 1970s, many had taken out loans to buy more land on the assumption that crop prices would keep rising at an extraordinary clip. When food prices fell and interest rates rose, people across Middle America lost their farms. They protested by driving their tractors to Washington and circling the Federal Reserve’s grand marble headquarters.”
The politicians also protested. As Irwin writes ““We’re destroying the American Dream,” said Republican representative George Hansen of Idaho. A building-trades magazine accused Volcker of “premeditated and cold-blooded murder of millions of small businesses.””
But Volcker stayed put and finally managed to bring the inflation monster under control with the bitter pill that he administered. By July 1982, inflation had more than halved from its high of 15 percent in March 1980.The steps taken by Volcker ensured that the inflation fell to 3.2 percent by 1983. After this, the United States saw solid and almost non-stop economic growth till 2000, when the dotcom bubble burst.
Interestingly, Volcker may not have been very popular in the first few years of his tenure, but now he is among the few men in finance who continues to be well respected.
At certain points of time economies need to be administered the bitter pill if they are to be healed back to health again. India is in a similar position currently. Tough economic decisions will have to be made and these decisions will be unpopular. And given that there will be protests. When there are protests the easy way is to “rollback” whatever is being protested against. But that will only postpone the problem.
The Narendra Modi government of course cannot operate totally like Volcker. Volcker was not elected by the people and he did not have to explain what he did directly to the American citizens. He did have a lot of explaining to do to the American Congress though.
But what the Modi government can learn from Volcker is that at times it is important to administer the bitter pill to the economy and not get bogged down by the protests. The important point here is that the Modi government needs to communicate more and more in order to explain its decisions to the people. This can be done through the social media, ministers talking to the media and even putting out detailed press releases. Also, it should not fall prey to the “rollback” culture made so popular by the Congress.
The article originally appeared on www.firstbiz.com on June 25, 2014
(Vivek Kaul is a writer. He can be reached at [email protected])

 

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) 

Volcker rule may not rein in speculation in Wall Street

Wall-StreetVivek Kaul 
Various regulators in the United States working together managed to finalise the final version of the Volcker rule on December 10, 2013. The rule is named after the former Chairman of the Federal Reserve, Paul Volcker.
Volcker was the Chairman of the Federal Reserve between 1979 and 1987 and famously raised interest rates to close to 20% in order to kill double digit inflation.
Before understanding what the Volcker rule is, it is important to understand how banks used to operate till a few years back. Banks borrowed money through deposits at a certain rate of interest and lent it out as loans at a higher rate of interest. The difference between the two rates of interest was the money that a bank made. It was as simple as that.
But somewhere along the line, banks started to make one way speculative bets on financial assets using their own funds. These bets, referred to as proprietary trading, ballooned in the run up to the financial crisis. As Michael Bobelian writes on Forbes.com “Leading up to the financial crisis, proprietary trading, in which financial institutions invested their own funds, ballooned as it became more lucrative. Those riches also carried with them immense risks that nearly destroyed the financial sector in 2008.”
Paul Volcker suggested that banks whose deposits are insured by the Federal Deposit Insurance Corporation(FDIC) in the United States be prohibited from proprietary trading. The idea was to reduce the risk that it built into the financial system, leading to the government and the Federal Reserve having to come to rescue of all and sundry in the end. As Timothy Noah writes on www.msnbc.com “The rule’s overarching goal is to reduce the type of speculation by banks that contributed to the 2008 crisis.”
But there are certain exemptions that are allowed. Banks are allowed to function as market makers and buy financial securities to meet the demand from their customers. And this is where things start to get interesting.
As John Cassidy writes on www.newyorker.com “There are also exemptions for market-making, in which the banks build up sizable positions in all sorts of securities, supposedly with the sole intention of having enough on hand to meet the demands of clients and for hedging risks taken elsewhere in the firm. But how can any outsider know whether a given trading desk is buying tech stocks, for example, to anticipate customer demand or to wager on the Nasdaq going up?”
What does the Volcker rule have to say with regard to this? It allows banks to buy financial securities to meet “the reasonably expected near-term demands of clients, customers, or counterparties.” The phrase reasonably expected is not defined.
There are also certain situations in which proprietary trading is allowed. “It doesn’t apply to government bonds, including those issued by the federal mortgage agencies and by municipalities. If Goldman or Morgan Stanley want to short Treasury securities, or the city of Chicago, they can go right ahead. Also excluded from the restrictions are physical commodities, such as oil and gold,” writes Cassidy.
Interestingly, a major reason why a lot banks(both investment banks and normal banks) got into trouble around the time the financial crisis first broke out was the fact that they held some of the junkiest subprime mortgage backed securities on their own books, in the hope of making higher returns. These were essentially speculative bets on the housing market in the United States. Cassidy points out that the Volcker rule does not nothing to stop banks from making these bets.
Also, banks are allowed to enter certain trades that may look like proprietary trades, as long as they hedge their bets. But the question is can a differentiation always be made? Neil Irwin of The Washington Post explains this point in great detail on his blog.
Irwin takes the example of bank which has bought options betting that the value of the Brazilian real may fall against the dollar. The regulator may catch on to this and ask the bank “What is this!” you say. “You are speculating that the real will fall against the dollar. You know you aren’t allowed to speculate on currencies under the Volcker Rule.”
The banker though may have a perfect explanation for it, writes Irwin. “What are you talking about? I’m not speculating on the Brazilian currency! I have this huge loan that I made to a Brazilian construction company. And they make all their money in reals. So all I’m doing is guarding myself against the risk that the real falls, and I won’t get my loan repaid. This is reducing the risk that the bank faces, not increasing it!”
Lets understand this in a little more detail. Currently one dollar is worth around 2.34 Brazilian reais (plural of real). Lets say the bank gives a loan of $10 million to a Brazilian construction company. The construction company converts the dollars and gets 23.4 million reais in return.
Now lets say, by the time the loan is to be repaid one dollar is worth 5 Brazilian reais. In order to repay the $10 million, the Brazilian construction company will now need 50 million reais ($10 million x 5). It may not have that kind of money and may choose to default totally or partially. This will amount to a huge loss for the American bank.
But to take care of this loss the bank has hedged the loan by buying options. And the pay off from the options will make up for the loan losses. Given this, it will be difficult to differentiate between a speculative trade and a hedge in many cases.
One school of argument being currently put forward is that the Volcker rule is already having an impact, given that some of the biggest banks on the Wall Street have already closed down their proprietary trading divisions.
As Kevin Roose writes on www.nymag.com “Goldman Sachs had an entire unit, Goldman Sachs Principal Strategies, designed for prop trading – essentially, betting the firm’s own money on stuff. It was closed, and most of its people moved to a private-equity firm. Morgan Stanley had a prop-trading unit with 60 employees. It got closed, too. So did the prop-trading divisions at Bank of America and Citigroup.”
The conspiracy theory, as a Wall Street veteran told me is that banks are “setting up their traders as “independent” hedge funds.” If this turns out to be true, the overall riskiness of the financial system is unlikely to come down.
To conclude, time will tell how successful the Volcker rule will turn out to be. It might succeed in the short run, but I am doubtful whether it will succeed in the long term. It is worth remembering that the best brains work for the Wall Street, and they will find a way around it.
The article originally appeared on www.firstpost.com on December 12, 2013 
 (Vivek Kaul is a writer. He tweets @kaul_vivek) 
 

Is Rajan trying to do what Paul Volcker did in the US ?

ARTS RAJANVivek Kaul  
Going against market expectations Raghuram Rajan, the governor of the Reserve Bank of India(RBI), raised the repo rate yesterday by 25 basis points (one basis point is one hundreth of a percentage) to 7.5%. Repo rate is the interest rate at which RBI lends to banks.
It was widely expected that Rajan will cut the repo rate. But that did not turn out to be the case. In his statement Rajan explained that he was worried about inflation. As he said “recognizing that inflationary pressures are mounting and determined to establish a nominal anchor which will allow us to preserve the internal value of the rupee, we have raised the repo rate by 25 basis points.”
The RBI’s Mid-Quarter Monetary Policy Review echoed a similar sentiment. “What is equally worrisome is that inflation at the retail level, measured by the CPI, has been high for a number of years, entrenching inflation expectations at elevated levels and eroding consumer and business confidence. Although better prospects of a robust kharif harvest will lead to some moderation in CPI inflation, there is no room for complacency,” the statement pointed out.
Rajan, as I explained yesterday, believes in first controlling inflation, instead of being all over the place and trying to do too many things at once. As Rajan wrote in a 2008 article (along with Eswar Prasad) “The RBI already has a medium-term inflation objective of 5 per cent…But the central bank is also held responsible, in political and public circles, for a stable exchange rate. The RBI has gamely taken on this additional objective but with essentially one instrument, the interest rate, at its disposal, it performs a high-wire balancing act.”
And given this the RBI ends up being neither here nor there. As Rajan put it “What is wrong with this? Simple that by trying to do too many things at once, the RBI risks doing none of them well.”
Hence, Rajan felt that the RBI should ‘just’focus on controlling inflation. As he wrote in the 2008 Report of the Committee on Financial Sector Reforms “The RBI can best serve the cause of growth by focusing on controlling inflation and intervening in currency markets only to limit excessive volatility…an exchange rate that reflects fundamentals tends not to move sharply, and serves the cause of stability.”
Given this, Rajan’s strategy seems to be similar to what Paul Volcker did, as the Chairman of the Federal Reserve, to kill inflation in the United States, in the late 1970s and early 1980s. On August 6,1979, Volcker took over as the Chairman of the Federal Reserve of United States .
When Volcker took office, things were looking bad for the United States on the inflation front. The rate of inflation was at 12%. In fact, the inflation in the United States had steadily been going up over the years. Between 1964 and 1968, the inflation had averaged 2.6% per year. This had almost doubled to 5% over the next five years i.e. 1969 to 1973. And it had increased to 8%, for the period between 1973 and 1978. In the first nine months of 1979, inflation had averaged at 10.75%. Such high inflation during a period of peace had not been experienced before. As inflation was high people bought gold. On August 6, 1979, the day Volcker had started with his new job, the price of gold had stood at $282.7 per ounce. On August 31, 1979, gold was at $315.1 per ounce. By the end of September 1979, gold was quoting at $397.25 per ounce having gone up by 26% in almost one month.
On January 21, 1980, five and a half months after Volcker had taken over as the Chairman of the Federal Reserve of United States, the price of gold touched a then all time high of $850 per ounce.
In a period of five and a half months, the price of gold, had risen by an astonishing 200%. What was looked at as a mania for buying gold was essentially a mass decision to get out of the dollar. Given this, lack of stability of the dollar, Volcker had to act fast.
After he took over, the first meeting of the Federal Open Market Committee (FOMC) was held on August 14,1979. FOMC is a committee within the Federal Reserve, the American central bank, which decides on the interest rate. The members of the committee expressed concern about inflation but they seemed uncertain on how to address it.  In September 1979, the FOMC raised interest rates. But it was split vote of 4:3 within the seven member committee, with Volcker casting a vote in favour of raising interest rates. Volcker clearly wasn’t 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 the interest rate till it 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, unemployment rate crossed 10%, the highest it had reached since 1940 and nearly 12 million Americans lost their jobs. During the course of the same year nearly 66,000 companies filed for bankruptcy, which was the highest since the Great Depression.
And between 1981 and 1983, the economy lost $570 billion of output. But the inflation was finally brought under control. By July 1982, it had more than halved from its high of 15% in March 1980. The steps taken by Paul Volcker ensured that the inflation fell to 3.2% by 1983.
By continuously raising interest rates, Volcker finally managed to kill inflation. This ensured that the confidence in the dollar also came back. By doing what he did Volcker established was that he was an independent man and was unlike the previous Chairmen of the Federal Reserve, who largely did what the President wanted them to do.
In fact, when Arthur Burns was appointed as the Chairman of the Federal Reserve on January 30, 1970, Richard Nixon, the President of United States, had remarked that “I respect his independence. However, I hope that independently he will conclude that my views are the ones that should be followed.”
The feeling in the political class of India is along similar lines. The finance minister expects the governor of the RBI to bat for the government. But that hasn’t turned out to the case. The last few RBI governors (YV Reddy, D Subbarau) have clearly had a mind of their own. And Raghuram Rajan is no different on this front. His decision to raise interest rates in order to rein inflation is a clear signal of that.
But the question is can the RBI do much when it comes to controlling consumer price inflation(CPI)? Can Rajan like Volcker did, bring inflation under control by raising interest rates? Or can he just keep sending signals to the government by raising interest rates to get its house in order, so that inflation can be brought under control?
In India, much of the consumer price inflation is due to food inflation, which currently stands at 18.8%. While overall food prices have risen by 18.8%, vegetable prices have risen by 78% over the last one year. As a discussion paper titled Taming Food Inflation in India released by Commission for Agricultural Costs and Prices (CACP) in April 2013 points out, “Food inflation in India has been a major challenge to policy makers, more so during recent years when it has averaged 10% during 2008-09 to December 2012. Given that an average household in India still spends almost half of its expenditure on food, and poor around 60 percent (NSSO, 2011), and that poor cannot easily hedge against inflation, high food inflation inflicts a strong ‘hidden tax’ on the poor…In the last five years, post 2008, food inflation contributed to over 41% to the overall inflation in the country.”
The government procures rice and wheat from farmers all over the country at assured prices referred to as the minimum support price. This gives an incentive to farmers to produce more rice and wheat for which they have an assured customer, vis a vis vegetables.
As a discussion paper titled National Food Security Bill: Challenges and Options released by CACP points out “Assured procurement gives an incentive for farmers to produce cereals rather than diversify the production-basket…Vegetable production too may be affected – pushing food inflation further.”
There is not much that the RBI can do about this. As Sonal Varma of Nomura Securities puts it in a report titled RBI Policy – A Regime Shift “Inflationary expectations are elevated primarily due to supply-side driven food inflation. In the absence of a supply-side response, severe demand destruction may become necessary to lower inflationary expectations.” Hence, it remains to be seen how successful the Rajan led RBI will be at controlling inflation.
The article originally appeared on www.firstpost.com on Septmber 21, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)