Somewhat paradoxically, for historical reasons fascinating in themselves, there is a consensus that the task of controlling inflation is too politically sensitive to be entrusted to politicians. Inflation is thus handled by central banks, with appointed governors, supposedly shielded from political influence.

Every high-growth economy has some “healthy inflation” due to strong demand and rising labour costs. But there is also “unhealthy inflation”, caused by too much money chasing too few goods and by supply-side problems (say, when there is not enough supply of crude to meet the demand).

Central banks fiddle with liquidity, money supply and interest rates to target inflation. They often get it wrong. Central banks also have other tasks. They manage government borrowings. They handle forex reserves and target currency movements. They oversee the commercial banking system. They can get those things wrong as well.

The Reserve Bank of India is facing a serious dilemma at the moment. Trends across two of its priority areas suggest one course of policy action, whereas dealing with a third priority area may require it to do the opposite.

It is the central bank’s job to smoothen cycles of inflation, which are of course linked to growth and currency trends. If inflation is high, the central bank will raise policy interest rates and/or tighten money supply. If inflation is low, it will increase money supply and cut interest rates.

Central banks tighten or ease liquidity by changing cash reserve ratios and statutory liquidity ratios for commercial banks. Banks must keep a certain share of their assets in cash, or cash equivalents such as treasury bills. By raising or lowering the cash reserve ratios, the central bank can tighten or ease liquidity.

Another monetary instrument available to the central bank are the policy rates. Multiple interest rates rest on top of the policy rates, and on top of treasury bill yields. The central bank sets the policy rates at which it lends to, or borrows from, commercial banks. In India, these transactions involve selling and repurchasing bonds at agreed prices. The policy rates are thus known as the repurchase (or repo) or reverse repurchase (reverse repo) rate. Fixing a cut off yield on dated Treasury Bills, auctioned by the central bank on behalf of the government, also sets a ceiling on risk free returns. Treasury Bill yields and Repo rates are risk free since these are loans made to government and RBI. Commercial lending rates and bond market yields use the policy rates and the treasury bill yields as the benchmarks.

Central banks can also employ unusual measures. The Bank of Japan has a negative rate to combat deflation. The European Central Bank also has a negative rate. This means that a bank with surplus cash must pay to “lend” to the central bank. Hence, there is a huge incentive to extend commercial credit.

Another emergency measure is quantitative easing. This involves the central bank buying bonds and releasing cash into the economy to pump up liquidity. The 2008 subprime crisis triggered multiple rounds of quantitative easing in different currencies.

The Reserve Bank of India started raising its policy rates months ago. In its last policy review on October 3-4, the central bank did not raise the policy rates but warned that it was going to tighten liquidity. Its inflation target is ideally 4%, plus or minus 2%. To understand what this means, take a look at index construction.

The collapse of IL&FS has sparked a bond market crisis, with fears of a default pushing up yields. Photo credit: Reuters

Controlling inflation

The Reserve Bank uses the Consumer Price Index as the inflation benchmark. It is the basket of household expenditure weighted in proportion. Food is about 46% of the Consumer Price Index by weight, housing 10%, transport and communication 8.5%, fuel and power 7%, health 6%, education 4.5%, and clothing 6.5%.

The Consumer Price Index uses the averaged retail prices of 2011-’12 as the base. These prices are “normalised”. For example, if petrol averaged Rs 68.20 a litre in 2012 and cost Rs 81.30 in September 2018, the 2012 price may be set at base 100, meaning September’s will come to 119. The same method is used for all items.

These normalised, weighted costs are used to calculate the Consumer Price Index every month. The Consumer Price Index is then compared to that of 12 months ago to figure out the inflation rate the Reserve Bank is targeting. The Consumer Price Index for September 2018 was 140.3 compared to 135.2 for the same month in 2017. Since the September 2018 index is 3.77% higher, “retail inflation” is said to be rising at 3.77% year-on-year.

This is easy to understand and calculate. But there are methodological weaknesses. There are seasonal variations in prices and demand. People buy expensive clothes in winter and run air conditioners in summer. They spend more during festivals. Deseasonalising is tricky. It is even harder to account for black swan events, such as demonetisation and the roll-out of the Goods and Services Tax, which distort the normal demand-supply equation for extended periods, creating base effects that distort future calculations as well.

There is also always some volatility as food and fuel prices are, well, volatile. At first glance, the inflation rate looks good. It is very close to the 4% target and has fallen from a high of 5.2% in December 2017. The key item – food – is running at only 1.5% year-on-year. Even though fuel is up 8.5% year-on-year, the fuel weight is much lower than that of food.

But then there is also “core inflation”, the less volatile elements of the Consumer Price Index. For example, the cost of housing, and transport and communication does not shift that much month to month. But core inflation does not come down easily once it goes up. Core inflation is much higher than the Consumer Price Index, at around 5.85% year-on-year for September 2018.

The RBI’s Household Surveys indicate inflation expectations are high. This can be self-fulfilling. When inflation expectations are high, people buy less and businesses (run by people with high inflation expectations) jack up the prices to compensate for higher anticipated costs.

There are also fears that the rupee could weaken more. High crude prices will lead to a high Current Account Deficit, putting more pressure on the rupee. Raising rupee interest rates is one way to protect the currency since a higher real return may help induce forex inflows.

Hard currency conditions, meanwhile, are likely to tighten. The United States Federal Reserve tapered its quantitative easing starting in 2013 and it is now “quantitatively tightening”, selling bonds or letting them expire to lower liquidity. The American central bank has also raised policy rates several times and signalled that it will continue to do so through 2019.

Starting December 2018, the European Central Bank will also start scaling back its ongoing quantitative easing programme. The bank will probably hike interest rates in the second half of 2019. The Bank of Japan has also made noises about tapering an ongoing quantitative easing.

The other cause of worry for the Reserve Bank of India is the crisis in the financial sector. Banks are still struggling with high non-performing assets and the collapse of IL&FS has sparked a bond market crisis, with fears of a default pushing up yields.

The concerns about inflation and a weaker rupee have already led to the Reserve Bank hiking rates and it is getting set to tighten liquidity. But the financial sector crisis creates a conundrum. The classic way to deal with a financial crisis is to open the tap by cutting rates, and increase liquidity to keep credit flowing.

The Reserve Bank will have to step carefully around this mess. If the financial sector does not stabilise, all sorts of businesses could be in trouble. But if the tap is opened, it could lead to soaring inflation and a run on the rupee.

It won’t be easy solving this particular puzzle.