One day after the Reserve Bank of India raised interest rates for the 11th time in 17 months, Deputy Governor Subir Gokarn spoke candidly and in detail with Chaitanya Kalbag on the battle the central bank is doggedly waging against inflation and on the imperatives of a credible monetary policy that has to be aggressive and single-minded in forcing the price trajectory downwards again. Full transcript of the interview:
What is the tipping point? At what stage is the Reserve Bank going to decide that enough is enough and the interest rate increases are starting to have a negative impact on growth?
The answer to that lies in the guidance that we have given, the way we see the process playing out is that inflation over the past few months has been driven by a combination of two factors: There is still strong demand pressure in the economy and commodity prices has risen very sharply and that has reinforced the demand pressure so that we have had very visible pass-through of input price increases into general inflation. Obviously raising interest rates means trying to contain domestic demand and as that containment works then we should see inflation rates coming down in tandem with a little bit of a lag, but essentially the consequence of slowing or moderating domestic demand is going to be that inflation rates will fall.And this may be reinforced by a softening in commodities prices.
I think a very important precedent for this is what happened in the second and third quarters of 2008/09 when oil dropped very precipitously and because of high interest rates and global conditions demand also dropped very sharply; we saw inflation coming down in a matter of a few weeks from double digits to almost negative in a matter of a few months. Obviously we are not visualizing that kind of scenario. It was unique but the basic forces, the combination of commodity prices and demand moderation, still operate and so the turnaround, the downtrend in inflation may be more moderate than it was in that extreme situation but that is the basic process which we are visualising.
We have said that we expect inflation to start turning down around November or December.
We noticed the word credibility in the expected outcomes in the governor's statement…now the credibility part is important because there's a feeling that the Reserve Bank has become almost yesterday was obviously a big shock to many people in the market and in the business but there was a predictability to what was happening going to happen in terms of these interest rate cycle and that itself was starting to become a self-fulfilling prophecy in a fact. Would you agree?
I think we have to look at the May statements as a significant change in the pattern. When we moved from 25 (basis points) every six weeks to 50, then 25 and now 50 again, the May statement reflected a basic change in strategy driven by the fact that inflation had been a problem right through 2010 but somewhere around December or January it ratcheted up because of the impact of commodity prices. So at that point we had to take a view on…whether this could be transitory or more persistent, what the budget would do in terms of fiscal consolidation … a number of other variables had to be brought into play.
Once the situation had become clearer, in May we decided to move to a different trajectory which is more assertive action. That was based on the understanding that not only was inflation was higher because it had moved from an average of about seven per cent in the second half of 2010 to about 9.5 per cent, but it would also be persistent. That took us to the 50 basis points hike in May. Obviously we did not see adequate reason now to change that policy. The surprise that the markets manifested was perhaps based on the fact that they did not appreciate the full significance of the shift in May. Once you committed to a trajectory, there is an issue of credibility in sticking to it. Having moved to a stronger trajectory, it would be premature to withdraw from it at this stage saying that circumstances have changed, because they haven't changed that much.
On the RBI single-handedly shouldering the burden of attacking inflation:
I don't think one would attribute these statements to frustration; they are based on realistic assessments that a number of different things have to be done in order to deal with the pressures that we are dealing with now, some of which are related very strongly to capacity bottlenecks in various sectors, as we mentioned, like food and infrastructure. I think the reality is that the less response there is on the supply side, as long as a demand-supply gap persists and inflation pressure remains, that the risk of inflation spiraling increases, through the expectations and through the behaviour of workers or producers, as price-rise expectations get entrenched. So what then happens is that monetary policy has to work even harder to offset those expectations. I think the metaphor of one wheel moving and the other stuck is a nice visual that could mean that you end up going around in circles. But I think this is not an issue of circular motion …I think it's really an issue of offsetting or compensating. That is why we are emphasizing the concept of complementarity, that it is only when supply and demand are more or less in sync that inflationary pressures start to abate.
I don't like to use the word overheating because that would suggest a dire situation. I think we do have several demand-supply imbalances. We have pointed to food and infrastructure. There are demand-supply imbalances in labour as well. (Paradoxically) we find people being available but the required skills not being available. These are bottlenecks which can be addressed, not overnight, but in fairly short periods of time by policy action, budgetary commitments and so on. As long as we keep doing this, as long as we keep addressing bottlenecks as they emerge, this persistent inflation pressure is not going to become a factor. But if we don't address them, then if you are always pushing the frontiers, pushing the constraints, then the inflationary pressure is going to persist.
On bottlenecks, skill-sets, comparison with China:
Once you know that the bottlenecks are going to emerge, then you have to anticipate and prepare for them and you can't wait until they actually happen. But since we have seen that these are bottlenecks, we have seen for example very importantly, I have been talking about protein shortages and in the last round of the NSS (National Sample Survey) for which the results have been published, the 2009/10 consumer expenditure survey, it's been validated I think very strongly that there is an enormous dramatic shift in consumption, food consumption, food as a share of overall consumption has gone down, within food there has been a shift away from carbohydrates, from cereals to proteins. What we have been seeing in terms of price dynamics is clearly being validated by these fundamental shifts in consumption patterns…so when we know this so then we have to reorient our agricultural incentives to ensure that what is being produced is what people are consuming more of.
Have you noticed any parallels in other countries that went through similar phases of development?
We have had episodes of inflation in many countries when they began their high-growth phase, but they have mainly been addressed.
Is the Indian economy punch-drunk with the repeated blows from the central bank? Or do you see a moderation in potential bubbles like the property markets?
Well on property prices … we have a property price index…and that is suggesting based on data up to the last quarter that property prices continue to rise in most cities. Five of the seven show increases, two are showing signs of plateauing. Anecdotally, one can see some signs of prices starting to moderate. Now this essentially comes from the fact that there is apparently a fair amount of unsold stock and that is being constrained because of interest rates so developers are starting to ease on prices. That is not such a negative development. I mean if developers feel it is still worth their while selling properties at lower rates, that is to the benefit of everybody.
But the issue you are raising is of successive hikes. Clearly there is a lag in terms of how much time it takes for the interest-rate action to translate into actual activity. But there is a much more powerful and immediate impact on expectations - which brings me back to the credibility issue, to the extent that expectations are immediately shaped by actions and a very strong action has a much more powerful effect on expectation, then part of the battle is being won. People now accept that they cannot build into their decision-making the prospect of high inflation. So they will have to take that into account in their consumption or investment decisions.
On RBI being given a clear mandate:
I think it has always been an issue of priority. For a central bank the priority is always inflation. Of course, you can make a very explicit commitment to that priority in the form of an inflation target and de-prioritise everything else, or you can try and balance that with other priorities so that there is no conflict between them. So I would describe our ordering of priorities as inflation always, but to the extent that if it can be reconciled with growth objectives then that reconciliation will be attempted. But at this point, we clearly see that it is worth some slowing down of growth in order to bring inflation down from these levels, and that is the message we have been sending through our last two policy statements.
Should there have been bigger hikes earlier?
I think we have to keep in mind that this is not a continuity of an inflationary process. There was a distinct break in the inflationary process in December-January. Up until December, if you look at the headline numbers there was stability and our core inflationary measure, that is non-food manufactured products, was actually starting to come off a little. So we hadn't stopped our calibrated action, although we actually paused in December. So the calibrated action was warranted and part of this was motivated by signs from the IIP that there was some moderation in industrial production. But the ratcheting, the point of inflexion occurred in January, when the combination of domestic demand and commodity-price inflation took the inflation number to a different trajectory altogether. Had we anticipated this commodity price spiral, perhaps the action could have been front-loaded, but we were operating under a different set of conditions in 2010, to which we felt the most appropriate response was this calibrated action. But then the inflation number went up very sharply and in response to that we had to re-think our strategy, which we did.
Trajectory to 7 per cent target for March:
It is not a target, it is a projection for year-end. Now implicit in that story is that, once it starts settling down, it will continue to trend down, so March is not the end of that process. We obviously expect to see it move down towards what we consider an acceptable. Once it starts to move down it will stay down. At this point we expect that trajectory to start around November or December, so we are looking at relatively high inflation numbers up to that point. We do have a roadmap in place, and we have said we will review our stance at the time when we see this trajectory manifesting. This could of course be impact favourably by commodity price developments, or by a somewhat sharper than what is currently visible moderation in demand, which will also help inflation numbers come off more sharply.
Global shocks and the prevalence of inflation:
This is a general situation for all emerging economies central banks, or for that matter for all central banks. But I think the key issue is, what is the degree of exposure or what are the points of vulnerability? And do we have adequate resources or ability to cover these points of vulnerability? In the immediate context, there is an issue of long-term or medium term growth in these economies, which may have a bearing on our exports or investment decisions by our producers who are catering to these markets or sourcing from these markets. But the immediate impact is probably some dislocation, some disruption in financial markets. And from that viewpoint, we don't really know, we have no basis for predicting what the outcome of a potential default or the lack of an agreement on a debt ceiling in the US will be.
So we do an assessment - if there were to be a significant capital outflow, do we have enough liquidity to cover it? And we are fairly comfortable with the quantum of liquidity that we have. If there are significant inflows how are we going to deal with it? That really fits into a contingency plan of how we will deal with large, lumpy inflows without letting them become too disruptive. But the Indian exposure to the global economy is not that large.
On Indian companies looking overseas for borrowing:
That is part of globalization, I think that is true in any country, that any company, that can access global markets is doing so if it finds it more attractive than domestic markets. So you have got to make these choices based on relative costs and returns. And that is not something we want to disrupt, because that is part of the overall objective of globalization.
I think, in terms of immediate significance, we certainly look at the amount of money that Indian companies are borrowing from abroad as a result of finding better interest-rate deals. We raise interest rates, they go out looking for money. We don't want to stop that, within of course the broad limits of debt exposure and so on. If they are going to find more attractive deals and make investments based on that, it is not an issue. We should not have a problem with that. In terms of quantity, it is not very large, the actual ECB flows are relatively small percentages of total investments. So it is not an issue of great significance I would say.