Control inflation by acting on liquidity Inflation in India cannot be described just as ‘cost­push’; an abundance of liquidity has been an important factor The recent action of the Re­ serve Bank of India (RBI) to raise the repo rate by 40 ba­ sis points and cash reserve ratio (CRR) by 50 basis points is a recog­ nition of the serious situation with respect to inflation in our country and the resolve to tackle inflation. Inflation has assumed a menacing proportion in almost all countries. The situation is the worst in the United States where the consumer price inflation stood (in March 2022) at 8.56%, a level not reached for several decades. Consumer price index (CPI) inflation in India stood (in March 2022) at 6.95% . It is expected to rise further in April. India’s CPI inflation has been fluc­ tuating around a high level. As ear­ ly as October 2020, it had hit a peak of 7.61%. It had remained at a high level of over 6% since April 2020. It did come down after De­ cember 2020 but has started rising significantly from January 2022. On the other hand, the Whole­ sale Price Index (WPI) inflation had remained in double digits since April 2021. The GDP implicit price deflator­based inflation rate for 2021­22 is 9.6%. Impact on production Even though the RBI’s mandate is with respect to CPI inflation, poli­ cymakers cannot ignore the beha­ viour of other price indices. In the 2008­09 crisis, central banks of developed countries, particularly the Fed, had been blamed for over­ looking the sharp rise in asset pric­ es, even though CPI inflation was modest. After the advent of COVID­19 , the major concern of policymak­ ers all over the world was to revive demand. This was sought to be achieved by raising government expenditure. This is the standard Keynesian prescription. The sev­ ere lockdowns imposed to prevent the spread of COVID­19 restricted the mobility of people, goods and services. Thus, the expansion in govern­ ment expenditure did not imme­ diately result in increased produc­ tion in countries where the lockdown was taken seriously. In­ dia belongs to this category. As V.K.R.V. Rao pointed out in the 1950s, the Keynesian multiplier did not work when there were sup­ ply constraints as in developing countries. That is why he argued that the multiplier operated in no­ minal terms rather than in real terms in such countries. Someth­ ing similar has happened in the present case where the supply constraint came from a non­mobil­ ity of factors of production. Issue of inflation Nevertheless, the prescription of enhanced government expendi­ ture is still valid under the present circumstances. Perhaps the in­ crease in output could happen with a lag and also with the relaxa­ tion of restrictions. Initially, the fo­ cus of monetary policy in India has been to keep the interest rate low and increase the availability of liquidity through various chan­ nels, some of which have been newly introduced. However, the growth rate of money was below the growth rate in reserve money . This is because of lower credit growth which also depends on bu­ siness sentiment and investment climate. Thus the money multi­ plier is lower than usual. The Go­ vernment’s borrowing pro­ gramme which was larger went through smoothly, thanks to abun­ dant liquidity. Even as the economy picked up steam in 2021­22, inflation also be­ came an issue. As mentioned at the beginning, this is a worldwide phenomenon. In the U.S., the ex­ planation has been quite simple. There has been a balance sheet ex­ plosion of the Fed. On January 1, 2020 the total assets (less some items) of the Fed stood at $4.17 tril­ lion and in April 2022, at $8.96 tril­ lion. This massive expansion in as­ sets is the result of quantitative easing which essentially means li­ quidity support provided by the Fed. The Fed Chairman has made strong statements expressing the need to reduce the size of the as­ sets. The Fed is planning to shrink its balance sheet by $95 billion a month. It raised the policy rate by 50 basis points a few days ago. In India too there is a shift in mone­ tary policy. The latest monetary policy reiterates the stance as one of “to remain accommodative while focusing on withdrawal of accommodation to ensure that in­ flation remains within the target going forward, while supporting growth”. Without efforts to curtail liquidity, inflation will not come down. I go back to a point which I have been making several times recent­ ly. While discussing inflation, ana­ lysts including policymakers focus almost exclusively on the increas­ es in the prices of individual com­ modities such as crude oil as the primary cause of inflation. The Russian­Ukraine war is cited as a primary cause. True, in many sit­ uations including the current one, they may be the triggers. Supply disruptions due to domestic or ex­ ternal factors may explain the be­ haviour of individual prices but not the general price level which is what inflation is about. Given a budget constraint, there will only be an adjustment of relative pric­ es. Besides the fact that any cost­ push increase in one commodity may get generalised, it is the ad­ justment that happens at the ma­ cro level which becomes critical. A long time ago, Friedman said, “it is true that the upward push in wag­ es produced inflation, not because it was necessarily inflationary but because it happened to be the me­ chanism which forced an increase in the stock of money”. Thus, it is the adjustment in the macro level of liquidity that sustains inflation. Inflation and growth The possible trade­off between in­ flation and growth has a long his­ tory in economic literature. The Phillip’s curve has been analys ed theoretically and empirically. To­ bin called the Phillip’s curve a ‘cruel dilemma’ because it suggest­ ed that full employment was not compatible with price stability. The critical question flowing from these discussions on trade­off is whether cost­push factors can by themselves generate inflation. To­ bin said at one place that inflation ‘is neither demand­pull nor cost­ push or rather it is both’, even though he did not agree with Friedman’s extreme position that there would be no pure cost­push inflation. In the current situation, it is so­ metimes argued that inflation will come down, if some part of the in­ crease in crude prices is absorbed by the government. There may be a case for reducing the duties on petroleum products for the simple reason that one segment of the population should not bear exces­ sive burden. The same considera­ tion applies to food prices. But to think that it is a magic wand through which inflation can be avoided is wrong. If the additional burden borne by the government (through loss of revenue) is not off­ set by expenditures, the overall deficit will widen. The borrowing programme will increase and ad­ ditional liquidity support may be required. Concomitant decisions Commenting on the increase in re­ po rate and a rise in CRR, some have commented that this is dou­ ble whammy. No, these are con­ comitant decisions. Central banks cannot order interest rates. For a rise in the interest rate to stick, ap­ propriate actions must be taken to contract liquidity. That is what the rise in CRR will do. In the absence of a rise in CRR, liquidity will have to be sucked by open market oper­ ations. As the RBI Governor Shak­ tikanta Das put it in his statement, “Liquidity conditions need to be modulated in line with the policy action and stance to ensure their full and efficient transmission to the rest of the economy.” Inflation in India cannot be de­ scribed just as ‘cost­push’. Abun­ dance of liquidity has been an im­ portant factor. The April Monetary Policy statement talked of a liquid­ ity overhang of the order of ₹ 8.5 lakh crore. Beyond a point, infla­ tion itself can hinder growth. Ne­ gative real rates of interest on sav­ ings are not conducive to growth. If we want to control inflation, ac­ tion on liquidity is very much needed with a concomitant rise in the interest rate on deposits and loans.