Monetary Policy is Not Irrelevant

In this piece Surjit Bhalla of Indian Express bashes monetary policy and claims that he has found the panacea to kill inflation. The blurb of yesterday’s piece is that it is the MSP, the stupid. If you want to control inflation either reduce it or freeze it. And if you can’t then reduce interest rate. It will unleash the animal spirit of the Indian entrepreneurs. Indian growth story, he claims, will soon resume its pace. Much of Mr Bhalla’s claims are does not stand the scrutiny.

He begins his piece by saying that he is pleased to see CPI-inflation at 7.8%. Maybe, it is comforting for a man like him who gets a six-digit pay check. But he does not give this credit to RBI. He is of the view that RBI’s epic battle (by hiking the repo rate) since March 2010 has done little to control inflation, which is true. Both inflation and inflation expectation (a quarterly survey conducted by RBI) is very high, much beyond RBI’s comfortable level. But Bhalla gives credit to RBI’s clear communications: that it will keep repo rate high till inflation cools down, the talk of inflation targeting, anchoring inflation expectations. I will come back to this bit later.

Then Mr Bhalla claims it is sheer nonsense to explain Indian inflation by using stuffs like money supply, credit growth, and fiscal deficit. Econometrics investigation, he argues, offers zero explanation of Indian inflation.

Then one fine morning he invents a model that can solve age-old problem of inflation in India. How was he able come with this earth-shattering idea? He found the bad guy – minimum support price (MSP). He trusts his model so much that he challenges (oh yeah, it’s a friendly challenge!) RBI and other inflation-concerned people to prove him wrong. It succeeded intimidating me.

Unless we see his research paper we can’t comment his model. Unfortunately, downloading that paper was not possible. We don’t know if variables are subjected to unit root test (to test whether they are stationary). My first gut reaction after seeing his model how can one explain Indian Inflation – so complex – by using only one independent variable? I thought two-variable model exists in the intro econometrics textbooks to teach students in the classroom. No, i was wrong. It seems Mr Bhalla has taken it seriously, so seriously that he recommends his policy advice to GoI on the basis of his toy model.

Okay, let’s verify his claim that MSP is the stupid. He says MSP is rising because of political reasons. He can't be be ignorant of cost factors. MSP is rising because input cost is rising (see Chat 7 of Rajan’s speech). Cost is rising because government is setting administered prices free and rural wage (see Chat 8) driven by NREGA. Despite rising MSP, the terms of trade of output price to input price remains more or less same (See Rajan’s speech).  fact, the MSP provided by the GoI is comparatively much lower than what other countries provide.

But nobody downplays the role of MSP and the behind-scene politics. MSP growth is correlated with inflation. If we want the right MSP, then CACP should be empowered, given full autonomy and its recommendations must be mandatory. Institutional reform is necessary for CACP, FCI.

But saying that MSP is entirely behind the inflation is ridiculous. A simple way to verify his claim is to check what has happened to the price of non-MSP food crops. In fact, Ashok Gulati, former chairman of CACP argues that prices of non-MSP goods have risen more than MSP goods. If this is true, how logical is to argue that it’s the MSP, the stupid?

In his attempt to provide the earth-shattering model he loses sight of other factors that are also largely responsible. In my view, the elephant in the room is the distribution of foodgrains (see Kausik Basu’s paper).

Now assume that his model is a fine. So what does he recommend? Surprisingly, he did not say anything about MSP. You would expect him to recommend: either to freeze MSP or reduce it. But he recommends cutting repo rate. Since it does not stem from his model i guess it comes from his frustration to see RBI not paying heed to the Indian Express columns! (Just kidding). I guess he recognised the fact that is politically difficult to freeze MSP; so he did not say anything about what to do with MSP.

I have never seen anybody giving recommendations beyond what his model says. In his model, interest rate does not exist. How can he claim that interest rate does not matter for inflation? Further, if he believes that interest rate is holding investment, then he should show it. He should run a model regressing investment or growth on interest rate.

Now think of freezing MSP and assume that it is politically possible. Given that farmers are habituated to MSP growth every year they may react sharply by reducing production which will be double whammy. How much production will decline depends on the elasticity of production with respect to MSP. Freezing is good idea. But in the short run production will fall as a result of freezing and thus, price will rise. However, it is good in the long-run. So, this is not the right time to freeze given that input cost is also rising due to freeing up of administered prices.

Since he is bashing monetary policy because of high interest rates, it makes sense to ask: what is holding back the India Inc? High interest rate, stagnant global economy, economic uncertainty (govt’s policy mess/lack of clarity), corruption or agricultural stagnation?

He seems to believe that if we reduce interest rates then economy will bounce back. But he forgets that repo rate hike affects only 0.5 per cent of the entire borrowing of the banking system. Stated otherwise, it is not a constraint to credit supply and liquidity. This is a very important point which has been missed in the debate and discussion on monetary policy since Governor Subbarao was habituated with raising interest rates.

High interest rates are not a major problem that the India Inc is facing, rather the messy (now it is changing) domestic policy atmosphere that drags the India Inc. Rajan and his predecessor has ensured that liquidity is not a problem. And i also think that liquidity is not a problem. If Bhalla is very concerned about falling GDP figures, then he should pray that Modi government rolls out the much needed reforms almost in all sectors. I can bet that FDI and domestic investment will flow like flood. High interest rate sometimes lead to high investment. Yes, you hear it right. Mr Raj Chetty - a Harvard Professor, who won last year’s JBC medal – has shown it. His mentor Feldstein was convinced. Then why is investment low in India? I think Baker, Bloom, and Davis provides us the clue. It’s not the interest rate, the stupid, rather the economic uncertainty (foggy policy). A large literature has spawned off following the works of Baker, Bloom, and Davis (see India’s policy uncertainty index, it is very high as of August 2014) showing how high policy uncertainty leads to reduction in investment.

Sure, Rajan  can’t claim much credit for falling of inflation figures. It may be sheer luck. But today’s monetary policy (New Keynesian models) works on how well a central bankers communicates with public, expectation management, commitment to any monetary policy rules. It may be Prime Minister Modi too. People know Rajan means business. He talks tough on inflation and also he walks the talk. But then media reports said that Rajan might lose his job if Mr Modi comes to power. But this did not happen. Mr Modi reposed faith in Rajan. This sends a clear, loud, very strong message to the market that both are serious to kill inflation, the bad guy. This might have led public’s slowly-declining inflation expectation.

It raises question why RBI has so far not succeeded in bringing down inflation? RBI’s baby step approach (hiking repo by 25 basis points) is criticised by economists. That makes it always behind the curve. In my blog post i argued RBI should have gone for big hikes in repo rate if it was serious as Mr Subbarao lamented later.

So, where should we go from here? The declining numbers may give cheer to central bankers. But i think they can’t allow the situation go out of control. They should not reduce interest rate; rather keep it high where it is now. If they reduce it and if Inflation rises then both Mr Rajan and Mr Modi will lose credibility. Public will view that the duo have accepted defeat against the Inflation Goliath. This thinking has serious repercussion on future monetary policy and its success. It will jeopardise their credibility, inflation targeting will lose all its charm (i don’t endorse India to adopt inflation targeting. The time is NOT ripe now. However, we may try with some loose form of IT). People may lose faith in monetary policy.

More importantly, we have enough research showing that when headline inflation stays high for a lengthy period, it is highly dangerous for the economy for two reasons. First, it will lead to permanently high inflation expectations. Second, high headline inflation or food inflation is translated in to high non-food or core inflation via high and sticky inflation expectation (see Walsh, Prachi Mishra).

Indian inflation is so complex that any careful student of inflation would adopt a balanced view: it is due to demand factors like money supply, fiscal deficit, NREGA expenditure, shifting dietary pattern (due to rising rural wage?); and supply side issues like MSP, distribution of foodgrains, poor monsoon (resulting agricultural falling output), international raw material prices, global prices of oil products and foodgrains. And yes, exchange rate is also important. He seems to discredit all those factors.

Since, RBI has been fighting an epic battle it must win at any cost. It can’t let the situation slip from its control at this time where victory seems visible. Let us hope that RBI wins this epic battle as soon as possible. 

Update
I found this IMF article by Rahul and Tulin which says  heightened policy uncertainty and deteriorating business confidence have played a key role in the recent investment slowdown.  This is basically what my blog post is arguing. (read here the blog post by the authors)

What should we tax: Nominal or Real Income?

The base of income tax all over the world is nominal income that you earned in the previous financial year. Although, it is plain and simple to collect tax on nominal income yet it has serious limitations. Suppose your monetary (nominal) income remains same but you witnessed inflation rising from 5% to 10%. Three types of response can happen. One, your income may raise fully to compensate the rise in inflation (this is your real income remains fixed); two, you may see partial compensation of monetary income; finally, you may see no upward adjustment of your income. In this case you suffered income erosion due to high inflation. Further, consider when inflation is high and variable and uncertain nobody can perfectly predict the future income. That means you are bound see your income deprecating due to high inflation. The pain does not end here!

But does the income tax recognize the pain that you suffered from real income erosion due to high inflation? Sorry, no. It does not care what your real income is. It is interested to see what your monetary income is. It adds salt to your wounded area.

So, you see inflation leads to a double-loss of your real income. First, inflation does not bring an upward revision of your income. Second, you are taxed on your nominal income. A simple example is given to help you better understand this point. Suppose your income is 2 lakhs per annum. Tax exemption limit is Rs 1 lakh. That means taxable income is Rs 1 lakhs. Now bring inflation into discussion. Say, inflation is 10%. That is WPI has moved from 100 to 110. But your nominal income has not increased. So you suffered your first loss. You receive the second loss when you pay income tax. Tax rate is 10%. That means you have to pay Rs 10,000 to the tax department as your income tax. Real income is nominal income divided by inflation rate. Real income is (Rs 100000/110)*100 = Rs 90909. Income tax is Rs 90909*0.1 = 9091. So you save: Rs 10000 (which you have to pay when taxation is based on your nominal income) - Rs 90909 (which you have to pay when taxation is based on your real income) = Rs 909. This says if you are taxed on nominal income then you are paying Rs 909 more to income tax department. If your income remains same and inflation continues to rise at 10% per annum, in 5 years you can save: Rs 909*5 = Rs 4545. Not a small sum that you can choose to neglect!

So, i think is better to tax income not on the basis of what your monetary income is, rather what your real income is. The benefits are huge. Government has no other option than to rein in inflation. As a result, citizens will less bother about inflation. Governments have paid huge price for not controlling inflation. The recently concluded general election provided fresh evidence to it. 

A Comment on the Climate Change Report

Summer has become hotter and longer while that of winter has declined. The effects of climate change across the globe are asymmetric.

How do people react to the new IPCC report, released on March 31? Well, the important question is how rich countries have reacted to it. They will shrug and say ‘look, we have technology; we can handle the looming disaster’. First, they will be suspicious of the report. And complain that it is controversial. They will say the methodology and assumptions are not correct and al that blah blah. It has been, they go on complaining, written in such a manner that it demands rich countries to do more on reducing factors that cause climate change. Then they say we can devolve technology and we don’t have to sacrifice growth. Because in their dictionary the word “sacrifice” does not exist. These are classic cases of what you call fool. A natural disaster, unlike man-made disaster (like riots and all that) does not differentiate between rich or poor; or whether you are from the US or Bangladesh! All will be equally impacted. No question of inequality here! That is zero Gini coefficient! Yet they think that they can overcome these devastations. What a cruel joke? They also make nonsense arguments like the cost of taking climate change reducing actions far outweigh the benefits. Hence, it is best to do nothing and become witness to this devastation. Then they propose some smart concepts like carbon trading system which is unethical. This is unethical because rich countries don’t want to sacrifice growth. They have money and they can buy pollution from poor countries. In return poor countries have to reduce carbon dioxide and other GHGs. Since their manufacturing is primarily based on traditional technologies they have to sacrifice growth. This is the essence of all these smart concepts that those rich countries have innovated. It is high time that we acted now. It’s a question of now or never.

For god’s sake don’t get me wrong. I did not say that all actions have to be undertaken by rich countries. Poor countries must act. But when I see poor countries they say we can’t sacrifice growth. Hence we will reduce less GHGs and all that. They blame rich countries. And rich countries blame, though rationally, poor countries like India and China. For heaven’s sake stop this blame game and ACT NOW.

It is crucial to ask how youth react to such reports. Well, most are unaware and uninformed about the effects of climate change. And what about the educated youth? They hardly bother to care about it. They say: look, we have money. We can buy ACs, AC-cars and all that. They behave like rich countries. They are careless in using water, electricity, polluting air. Nothing can be sadder than this appalling attitude of youths upon whom the future of globe rests on.

How to Create More Inflation?

American economy has been struggling to recover from the Great Recession of 2008. Economists, policy makers, political leaders of the US have tried their best to end this recession as soon as possible. The US resorted to humongous fiscal spending, unconventional monetary policy. Yet, it is far behind its pre-crisis level when it comes to major economic indicators. To help recover the economy, New Keynesians, on the other hand, suggested higher inflation can do this job. The logic is simple: consumers would find spending now is prudent. People buy more and companies accelerate investments when things cost less today than tomorrow. Another benefit is that it makes your debt payments easier. So, how can we create more inflation? Well, some economists say the central bank should announce that it wants higher inflation. This announcement if perceived credible by public, they argue, is enough to take the economy to a higher inflation regime. And if does not, then central bank should be ready to act, that is, loosely speaking by printing more money. The Fed should go for an expansionary policy sufficient to raise the inflation that the Fed wants.

Yet, some argue engineering inflation by the Fed is not as easy as its advocates argue. Well, issues like political differences between Democrats and Republicans, credibility, time inconsistency, and reputation come into picture that makes the matter worse. For example, if inflation slips from the Fed’s control, then it has to create another recession to end higher inflation.

If we want more inflation raising the minimum wage, I think, will do that. So, if higher wage gets reflected in higher prices (in fact, it has some evidence), Keynesians argue, would lead to a rise in demand. And this brings cheer to New Keynesians since they argue that inflation can serve as a panacea to a zero-bound constrained economy.

But then why raise the minimum wage and distort the labour market? You will be tempted to think it may result in higher unemployment. The arguments for raising minimum wage are (a) minimum wage in the US has been kept on freeze since July 2009 (b) raising minimum-wage would provide a much-needed boost to the earnings of low-wage workers; that is it would raise standard of living and further, it would have a spillover impact on workers whose wages are just above the new minimum, (c) thus it would reduce poverty, (d) inequality has been sharply increasing and (e), wage has been slowly falling, though latest data suggest it is slowly rising. It might also lead to rise in productivity.

Okay. But what about its impact on unemployment? A large chunk of the research carried out by economists showed that it has zero or negligible impact on the employment of minimum-wage workers. But one thing that is missing in the current debate on minimum wage is that it might lead firms to substitute labor by capital.

Those who oppose this move argue that raising minimum wage is not a ‘panacea’ that can fix the economy. They argue rise in labor costs would cost employment. That is, firms would remove some of their workforce. I think they don’t take into account of employment addition due to rise in demand coming from hiked minimum wage. Further, they argue that increased wage would be visible in higher product prices. Another point they raise is that higher minimum wage would not substantially help the poor since many low-wage workers are not members of low-income families.

But i have two objections to the arguments made by the proponents of raising minimum wage: First, if wage is falling then we should see more jobs being created and recovery of the economy.  After all, Keynes said in 1936 that markets could not clear because wage (and price) was sticky. According to Keynesian camp, this was the major cause of protracted depression. So, falling wage is good sign that Keynesian devotees should cheer about. Second, what guarantee is there that hiked minimum wage would propel wage earners to spend more given that uncertainty remains high? They might choose to save if they are rational and far-sighted. We have evidence that they saved a lot from transfer payments.

Fair enough. So we learned from both these camps is this: a higher minimum wage will lead to increased money income in the hand of low-wage earners. So they would spend more. Further, firms would raise their prices to offset higher cost of labor. At the same time, firms might reduce hiring of labor and in fact reduce workforce. However, the balance of evidence suggests that rise in minimum wage have had negligible or no negative effect on the employment.

So, we have three benefits: inflation-induced higher demand, higher minimum wage-induced higher demand and rise in productivity; and one cost: rise in cost of labor. The biggest benefit is that no citizens will oppose it. That means tacitly they are favouring a higher inflation. Citizens will never allow raising inflation even if it is best for the economy and consumers. Hence minimum wage increase is the easiest solution to engineer inflation.