Monday, April 12, 2010

Fallacies… III

Continuing with the series once again. Something all of us are extremely tuned to hearing over and over again.

Fallacy 3) “Inflation has gone up, so interest rates will have to be hiked”: There are various types of inflation. Interests rates in specific can deal with only one type which is Demand pull inflation in discretionary items of consumption. But what are discretionary items of consumption?

Well, household consumption can broadly be divided into two parts. One part would include necessities, like food, fuel, electricity, cooking gas, etc., typically items which  a household would need to exist. These are classified as non-discretionary items of consumption as a household has no choice but to consume them. The other part consists of wants, not needs. This includes an own home, car, motorcycle, television, entertainment, eating out etc. These are typically expenses which a household wants to undertake to improve their quality of life, but aren’t really essential to exist.

The classification between these two categories differs from one city to another & even from one time to another. For example, own transportation is not a necessity in Mumbai because of its efficient public transportation system. But it may be considered a necessity in the National Capital Region. In a few years, once the Delhi Metro covers all corners of the NCR, own transportation will cease to be a necessity.

As far as non-discretionary items of consumption are concerned, these do contribute to economic growth, but not in any manner that can be codified into a model or law. For example, economic growth can lead to higher consumption of food-grains, but the relationship isn’t one that is predictable. One can look at how consumption patterns change when other countries went through a similar stage of growth to arrive at some idea of how it works, but predicting it with any accuracy is impossible.

Discretionary items, on the other hand, contribute directly to economic growth as incomes increase. There is more certainty and predictability her than in the case of non-discretionary items.

Coming back to inflation, to decide on a monetary policy response to it, its necessary to understand what its main causes are. If prices of discretionary items are rising due to an increase in demand without a corresponding increase in supply, interest rates are the correct tool. If interest rates are hiked, credit linked items like homes, vehicles, white goods, become more expensive in EMI terms which can lead to a fall in demand. In addition, the incentive to save rises which also results in a fall in demand. In this scenario, the prospects of demand cooling and prices coming down is very real as the right monetary policy toll has been used.

If on the other hand, the primary contributors to inflation are essentials, the monetary policy approach has to be different. It is impossible to control this form of inflation through interest rates. In fact, increasing interest rates in this environment is extremely harmful to the economy. If one assumes that income remains constant but the price of essentials rises, the amount of money available with households for discretionary expenditure is reduced to that extent. This would cause a drop in demand without any monetary policy action*. At this stage, to increase interest rates is to compound an already harmful situation. Demand, which is already depressed, will fall further and can result in a slowdown which will be extremely difficult to reverse. Also, monetary policy has an extremely small role to play in influencing the prices of these items. As mentioned in an earlier note, Inflation and the RBI, Neither will global oil prices change due to a change in India’s oil consumption, nor will people eat less if interest rates were to rise. Without any possible demand or price impact, using interest rates to control this kind of inflation is futile.

Unfortunately, the “law” requires and demands that the RBI act and it does. The RBI’s belief in this fallacious law has lead to many “incidents” in India’s economic history. Unfortunately, because of the RBI’s stubborn refusal to learn, we may be in the middle of one again.


* the recent increase in the price of Petrol and Diesel would increase expenditure on fuel by close to Rs. 2,400 cr. per month. This would have been otherwise available for discretionary expenditure.

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