India and the U.S.: A Tale of Two Ineffective Monetary Policies
Monetary policy refers to the process by which a country’s central bank controls money supply, often through the manipulation of interest rates, with the aim of promoting economic growth and stability while maintaining relatively stable prices and low unemployment. Monetary policy is either expansionary (mainly by lowering interest rates to combat a recession or a recessionary situation) or contractionary (raising interest rates to control inflation).
Interestingly, two different economies are following divergent monetary policies trying to solve their economic riddles—one is aiming to control high levels of inflation and the other is trying to move accelerate from “stall speed” (it currently stands on the precipice of economic recession) and an unacceptably high level of unemployment. The former is India; the latter is the U.S.
While the Reserve Bank of India (RBI) has been tightening the monetary screws (12 rate hikes in the past 18 months) more than ever before, the U.S. Fed is following ultra-expansionary monetary policy. However, success has been steadfastly eluding both. So, what gives?
Even at the cost of sounding clichéd, I am tempted to invoke a much abused phrase: “this time it’s different.” Past sins are clearly catching up now, rendering the monetary policy actions ineffective, when ordinarily they could have had an impact. To add to the woes, external factors are conspiring against success.
First let’s focus on India, where the average inflation since January 2010 is 9.6%.
The very fact that such a long tightening phase has failed to affect prices to the extent desired clearly indicates that inflation in India is mainly structural in nature (not cyclical). Years of neglect suffered by the agriculture sector are evident from the excessively low level of investment in the sector (Figure 2).
For a sector that supports about 65% of India’s population, there is a high price to be paid for such neglect. Not surprisingly, agriculture productivity levels in India are among the lowest in the world, as is evident from the yields shown in Figure 3.
Hugely inadequate physical infrastructure in agriculture (be it irrigation, cold storage facility, transportation, etc.) not only leads to low levels of productivity, but also to a huge loss of foodgrain due to improper storage. In India, more than 10% of foodgrain production gets wasted every year. As per the report of the 11th Planning Commission, preventable post-harvest losses of foodgrains are estimated at about 20 million tonnes a year, which is nearly 10.5% of the total production. To put things in perspective, India wastes close to 50% of Australia’s annual foodgrain production. Even a bumper crop is a problem for India and the country has had to resort to exporting foodgrains this year to tide over the storage problem, while every day millions of Indians go to bed hungry.
Not surprisingly, food inflation has remained persistently high in India, which has started to feed into overall inflation (Figure 4).
Moreover, as I have said in previous posts, inflationary pressures are also coming from the trade channel, as a result of the persistently high prices of oil and other commodities. The problem has been further compounded by the recent depreciation of the rupee (Figure 5), mainly on account of a perceptible retreat of FX flows due to the decreasing appetite for emerging market risk assets, as the European sovereign debt crisis continues to boil.
This is leading to imports becoming even costlier (negating the effect of some of the recent softening in commodity prices), further adding to inflationary pressures and thereby rendering the RBI’s monetary policy efforts futile. All this, despite clear evidence of demand destruction in India.
At the other end of the monetary policy spectrum lies the U.S. Fed…
As the global crisis erupted, the Fed acted quickly and eased money policy as fast as it could (Figure 6). However, with the Fed Funds rate at as close to zero as possible (and having been so for a longish period of time), the Fed has no more policy bullets, except for continuing to keep rates low, which is what it is doing. Here again, an extended period of ultra-low interest rates has not ratcheted up the economy.
With house prices yet to bottom out and unemployment levels remaining stubbornly high, the excessively leveraged U.S. consumer seems to be thoroughly down and out. The Conference Board Consumer Confidence Index stagnated at a two-year low in September (Figure 7), indicating that consumers are deeply worried about the state of the economy, and hence about their income and employment situations.
With consumers retreating and the crisis of confidence becoming all pervasive, the low interest rate regime has simply failed to spur the economy. The policy limitation that close-to-zero interest rates entailed forced the Fed to go for QE. Unfortunately, even this did not help much. Credit growth did not perk up materially and all that QE resulted in was rising excess reserves (rather than further lending), as credit-worthy borrowers refrained from borrowing and lending institutions also preferred to hold tight (Figure 8), given the crisis of confidence and the fear of tighter regulations.
With corporate profits moving to record-high levels, most companies, especially the nonfinancial ones, have preferred to use their cash to deleverage. The same has gone for credit-worthy consumers. Even the tax breaks and transfers have been, to a great extent, used to reduce debt. They have helped to arrest the slide in consumer spending, but have not stimulated an increase. Even the vast sum of money used for the “cash for clunkers” scheme or the “second home buying scheme” helped the economy to perk up only in the short term and the positive multiplier effect soon faded away. Of course, it did not help that Europe was hurtling faster and deeper into trouble.
The fact also remains that both the RBI and the Fed have not necessarily always taken the right decisions (though these been debated enough in the public domain and are beyond the scope of this article). Moreover, the politicians of both countries have played an important role in spoiling the party—in the U.S. through one-upmanship, and in India through sheer inertia (policy paralysis for some). This reminds me of what Charles Dickens wrote in “A Tale of Two Cities” (“it was the age of wisdom, it was the age of foolishness”), though in a slightly altered form: When the world needed wisdom, foolishness was more readily on display.
7 Responses to “India and the U.S.: A Tale of Two Ineffective Monetary Policies”
You mentioned inflationary pressures from the trade channel (see quote below). But I'd argue that fiscal subsidies are distorting the effect of price changes on the economy. The Indian government subsidies domestic fuel prices, so higher global prices just increase the fiscal deficit rather than being allowed to filter through to higher domestic prices. This distortion makes monetary policy more difficult.
"Moreover, as I have said in previous posts, inflationary pressures are also coming from the trade channel, as a result of the persistently high prices of oil and other commodities. The problem has been further compounded by the recent depreciation of the rupee (Figure 5), mainly on account of a perceptible retreat of FX flows due to the decreasing appetite for emerging market risk assets, as the European sovereign debt crisis continues to boil."
I believe that India's inflation problems are structural and caused by bad policy. RBI's policy has worked to keep demand side pressures from being inflationary, with perhaps a slight overshoot with the most recent rate rise. But as can be expected, it has been totally ineffective managing the supply side cost push. RBI has several problems in managing demand side inflationary pressure.
Firstly, with no core inflation measure available (one which strips out volatile food, commodity and energy prices); RBI has to tackle over-all inflation. And even the reliability of WPI & CPI are questionable.
The RBI lacks leading indicators which could indicate the likely direction of future inflation and growth. This greatly increases the risk of policy over-shoot.
Finally, RBI needs patience; they should not fight a battle that cannot be won. Targeting overall (not core) inflation of 4% to 6% is a dream, which will never be a realized for several years while real commodity prices rise.
Instead of frowning upon the RBI, perhaps we need to frown upon where the problem lies. Our political establishment fails us.
•GST is a potential disinflationary force – where is it?
•We impede the progress of our E&P industry (Reliance, Cairn & Canoro all recent example) every step of the way, instead of encouraging the sector to help reduce trade deficits; E&P too can be a powerful counter inflationary force.
•We discourage the building of strong farm to shop supply chains, preferring to leave our grain and vegetable rotting in the fields; instead of encouraging FDI in retail which will rapidly develop infrastructure necessary to reduce inflation.
•Where is the investment in roads and rail? Where is our investment in power? Where is our investment in water management? Where is our investment in agriculture? All stalled because of senseless governmental regulation. Opaque rules and regulations, cause uncertainty; uncertainty slows execution, which slows progress.
And, where is the investment in security? Where is the investment in a well functioning judiciary? We can have the best laws but when they cannot be enforced in a timely manner, it leads to discord. We create assets, but poor security makes it difficult to protect them. Without peace and law & order, the chances of enduring prosperity are remote.
Subsidies, use of senseless import/export taxes and control of several industries hurt too.
The stress from bad regulation and policy is best seen by looking at commodity prices in India Vs the world.
Commodity-India Price in Rs-Global Price in Rs.
Alumininium 2,675/2,205. Copper 9,189/7,416. Ni 22,973/18,610. Lead 2307/2035. Tin 25,526/21,300. Zn 2,491/1918. Steel HRC 872/707. Oil & Gas is in line with Brent but well above WTI; but cost to consumer is distorted through subsidies, state taxes & senseless regulation. How can a globally competitive industry be built on these foundations?
On agri commodities, Palm oil, Rubber, Coffee & cotton are more expensive, but wheat, maize and sugar are cheaper in India compared to the world. Here again, prices are low due to senseless control & regulations. Control discourages capacity creation as does poor infra & weak supply chains; control keeps capacity & prices low, it does not solve the problem, it simply shifts it away from the commodity price into a weak & sick industrial unit or an unnecessary fiscal deficit; but most importantly demand is not satisfied despite lower prices because of supply shortfalls and volatility (not enough warehouses to help reduce) and abject poverty. India has vast tracts where nutrician & hunger are at or below sub Sahara levels; its really quite disgusting.
The problems all stem from an inability to think long term.
The problem of inflation in India is both a demand side and supply side phenomena. Hence, policy corrections should be on both sides and notably, supply side. Can you please explain why you took WPI as a measure of inflation rather CPI?
The US needs to implement concrete, credible and growth-friendly fiscal consolidation plans to combat mounting public debts and check-in growth prospects. Only, expansionary monetary policy can no longer provide a fructify solution. Moreover, it has further spillover effects in terms of huge volatile capital inflows in emerging economies causing problems there.
I appreciate the comments made here and agree with the views. In fact, the views mentioned here have been variously articulated in my other posts here and in my website http://kunalsthoughts.weebly.com. Hence I did not articulate on all aspects, for sake of brevity.
W.r.t the query – why WPI, well isn't it the official inflation index? RBI does keep an eye on it, don't they? Well CPI numbers are even worse, but then when WPI does enough to justify my arguements, why bother to look at other indices which would have helped me reach the same conclusion anyway.