Raghuram Rajan’s Common Man Theory on InflationBy
SHEFALI ANAND
Reserve Bank of India Governor Raghuram Rajan listens to a question during an industry event in Mumbai, India, August 20, 2015. Danish Siddiqui/Reuters
India’s inflation has eased in recent months but not as far as the man or woman on the street is concerned, and that poses a challenge, Raghuram Rajan, governor of the country’s central bank said Monday.
Mr. Rajan, who is on leave from his position as a finance professor at the Booth School of Business in Chicago, donned his metaphorical mortar board on Monday to explain to a room full of bankers and executives in Mumbai why he hasn’t been in a rush to cut interest rates.
One key reason: the public doesn’t believe that inflation has fallen and is not convinced that when it does, it will stay down, the Reserve Bank of India governor said.
If consumers believe that inflation will remain high, they tend to save and not buy goods and services, thus tempering demand in the economy. Meanwhile, if manufacturers believe that the cost of their raw materials could inflate, they are likely to price their products at a higher rate.
Mr. Rajan noted that India’s average inflation was more than 9% between 2006 and 2013. The perception of the “Aam Aadmi,” or common man is that inflation will remain high even though in July, consumer prices rose by only 3.78%, the lowest pace of growth in eight months.
“The longer we had high inflation, the more the public’s expectations of inflation became entrenched at high numbers,” said Mr. Rajan. He said that for expectations to come down, India needs a long period of low inflation.
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The RBI needs to earn the public’s trust, he continued, that it will act against future inflationary threats. To build its credibility on this front, Mr. Rajan said the central bank is creating a framework that targets inflation.
He also addressed demands from industry that the RBI should cut interest rates again, which many believe will boost growth. The theory goes that if the benchmark interest rate was lowered by one percentage point, and banks pass on the lower rates to borrowers, then demand and consequently economic growth will likely pick up and stocks could jump.
But, Mr. Rajan said, cutting rates works only in the short term. If there aren’t enough goods and services to provide for the higher demand, then the lack of supply can cause inflation to spike sharply, forcing the central bank to raise rates again, he said.
“The boom and bust will not be good for the economy, and average growth may be lower than if the cut had not taken place,” he said. “That is why modern economics also says there is no long run trade-off between growth and inflation,” said Mr. Rajan.
Besides, he said that central banks shouldn’t be trying to boost the stock market by cutting rates. “We do not have to look too far beyond our borders to see the consequences of such boosterism,” said Mr. Rajan. China’s Shanghai Composite Index fell 8.5% Monday, as investors worried that the country’s economy could slow down sharply.
Mr. Rajan said demands for a cut in interest rates each time new data showed inflation is lower, overlook the fact that it can take several months for the effect of a change to be felt. “So in deciding policy today, we need to predict how inflation will look approximately a year ahead,” rather than reacting to recent inflation data, he said.
“Rate cuts should not be seen as goodies that the RBI gives out stingily after much public pleading. Instead, what is important is sustained low inflation,” said Mr. Rajan.
The central bank governor said his remarks should not be taken as an indication of what the RBI may or may not do at its next monetary policy meeting. He said that whether it cuts interest rates or not will depend on various factors, including the outcome of the monsoon rains, which can impact India’s food prices.
SHEFALI ANAND
Reserve Bank of India Governor Raghuram Rajan listens to a question during an industry event in Mumbai, India, August 20, 2015. Danish Siddiqui/ReutersIndia’s inflation has eased in recent months but not as far as the man or woman on the street is concerned, and that poses a challenge, Raghuram Rajan, governor of the country’s central bank said Monday.
Mr. Rajan, who is on leave from his position as a finance professor at the Booth School of Business in Chicago, donned his metaphorical mortar board on Monday to explain to a room full of bankers and executives in Mumbai why he hasn’t been in a rush to cut interest rates.
One key reason: the public doesn’t believe that inflation has fallen and is not convinced that when it does, it will stay down, the Reserve Bank of India governor said.
If consumers believe that inflation will remain high, they tend to save and not buy goods and services, thus tempering demand in the economy. Meanwhile, if manufacturers believe that the cost of their raw materials could inflate, they are likely to price their products at a higher rate.
Mr. Rajan noted that India’s average inflation was more than 9% between 2006 and 2013. The perception of the “Aam Aadmi,” or common man is that inflation will remain high even though in July, consumer prices rose by only 3.78%, the lowest pace of growth in eight months.
“The longer we had high inflation, the more the public’s expectations of inflation became entrenched at high numbers,” said Mr. Rajan. He said that for expectations to come down, India needs a long period of low inflation.
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The RBI needs to earn the public’s trust, he continued, that it will act against future inflationary threats. To build its credibility on this front, Mr. Rajan said the central bank is creating a framework that targets inflation.
He also addressed demands from industry that the RBI should cut interest rates again, which many believe will boost growth. The theory goes that if the benchmark interest rate was lowered by one percentage point, and banks pass on the lower rates to borrowers, then demand and consequently economic growth will likely pick up and stocks could jump.
But, Mr. Rajan said, cutting rates works only in the short term. If there aren’t enough goods and services to provide for the higher demand, then the lack of supply can cause inflation to spike sharply, forcing the central bank to raise rates again, he said.
“The boom and bust will not be good for the economy, and average growth may be lower than if the cut had not taken place,” he said. “That is why modern economics also says there is no long run trade-off between growth and inflation,” said Mr. Rajan.
Besides, he said that central banks shouldn’t be trying to boost the stock market by cutting rates. “We do not have to look too far beyond our borders to see the consequences of such boosterism,” said Mr. Rajan. China’s Shanghai Composite Index fell 8.5% Monday, as investors worried that the country’s economy could slow down sharply.
Mr. Rajan said demands for a cut in interest rates each time new data showed inflation is lower, overlook the fact that it can take several months for the effect of a change to be felt. “So in deciding policy today, we need to predict how inflation will look approximately a year ahead,” rather than reacting to recent inflation data, he said.
“Rate cuts should not be seen as goodies that the RBI gives out stingily after much public pleading. Instead, what is important is sustained low inflation,” said Mr. Rajan.
The central bank governor said his remarks should not be taken as an indication of what the RBI may or may not do at its next monetary policy meeting. He said that whether it cuts interest rates or not will depend on various factors, including the outcome of the monsoon rains, which can impact India’s food prices.
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