No Proof Required: Go on, do a Volcker, please -- Surjit Bhalla

There is, thankfully, a healthy debate in India on whether the RBI should cut the repo rate when it meets on December 2. The economy has yet to emerge from its doldrums, though green shoots of recovery are beginning to appear. Inflation has collapsed — yes, that is the right word — from double-digit levels to less than half that rate, and all in the space of 10-12 months. Some ordinarily reticent and subservient commentators have begun to shrug off their genuflection and have boldly come out by stating that maybe it is time for the RBI to begin cutting rates. And my friends console me by saying that there are other mad people in the world, besides me.

But in conversations with friends and experts, three common comments emerge. First, that one should let Raghuram Rajan alone, and not “pressure” him into cutting rates. To which my response is: which policymaker, in which free and democratic country, has, or should have, that luxury? You think Bernanke did not face pressure or criticism? Or Mervyn King? Or Janet Yellen? Or Mario Draghi? Is any one of them saying: Please don’t comment on how I should do my job?

The second cautious refrain from the experts is that Rajan should not cut rates now, but rather wait another six months and then cut by 50 basis points. My answer: No, he should wait until inflation is zero and then cut rates by 1,000 basis points.

The third and most important refrain from the RBI-should-delay-rate-cut apologists is that Rajan is trying to be a Volcker and we should allow that to happen. Because Volcker did not cut the Federal Funds Rate (FFR, equivalent to the RBI’s repo rate) until he was absolutely sure that inflation had been banished.

Every six months or so, I begin to think that I should change the long-running title of my column, “No Proof Required”. Change, because it has been used too long. But then along come moments like these, when such a title very accurately describes the nature of debate in India. You can say what you want with complete conviction and  complete lack of evidence. So I persist with the title as I examine Volcker’s fight against inflation. There are definitely lessons we, and the RBI, can learn.

Paul Volcker is rightly, and widely, credited with eliminating inflation from the US economy in the 1980s. In 1972, annual US CPI inflation averaged 3.3 per cent. Then came the Yom Kippur War and the quadrupling of oil prices in October 1973. US inflation climbed to double-digit levels in 1974, but soon fell back to a 5.5 per cent range for the next three years. In 1978, US inflation re-emerged (7.9 per cent) and jumped to 11.2 per cent in 1979, aided by a doubling of the price of oil in that year (due to the shakeout in Iran). Paul Volcker was appointed chairman of the Federal Reserve in August 1979.

At the time of his appointment, annual inflation was 11.5 per cent, a rate that peaked at 14.6 per cent in April 1980. The table documents the average levels of the FFR, CPI inflation and the change in these for the 20-year period of 1968-87.

The following facts stand out. First, note the equivalence of the change in the inflation rate and the change in the FFR for the two-decade period. Both change by zilch. Second, only in one year of Volcker’s tenure, and indeed in only one of these 20 years, in 1981, did inflation decline and the FFR was increased. But note what Volcker did the very year after, in 1982. With inflation declining by 420 basis points (1 percentage point is 100 basis points) to a quasi-respectable level of 6.2 per cent in 1982, Volcker reduced the FFR by a matching 410 basis points. The next year (1983), inflation fell by an additional 300 basis points, and the US economy had started to boom after the end of the recession in November 1982. What did Volcker do? He reduced the FFR by a more than matching 320 basis points. Over the next four years, inflation increased by 40 basis points (from 3.2 per cent in 1983 to 3.6 per cent in 1987), and the FFR declined by an additional 240 basis points (from 9.1 per cent in 1983 to 6.7 per cent 1987).

The second lesson from Volcker history is that, when the inflation rate fell by over 400 basis points in 1982, he took that fall as structural. Of course, he could have been wrong when he lowered the rates by 410 basis points. Oil prices averaged $33.6 per barrel that year, not far from the annual peak of $37 per barrel reached in 1980. He did not argue that maybe oil prices would rise further and, therefore, better wait to cut rates (another six months? Another year?). Nor, when the economy was booming at over a 5 per cent rate in 1983, the first year after the recession, did Volcker argue for a delay in reducing the FFR. Indeed, 1982 and 1983 were witness to a cumulative reduction in average FFR of over 700 basis points.

The hard truth facing the RBI is that year-on-year inflation in India was 11.2 per cent in November 2013. November 2014 CPI, to be released in a couple of weeks, is likely to come in with a four-handle and maybe lower than 4.5 per cent. That would make it close to a 700-basis point decline in one year. The question the RBI needs to ask is: What would the greatest inflation fighter, Volcker, have done?

No need to ask, just do what he did. And he did not wait until inflation was down to 4 per cent before he started cutting rates. He cut rates when inflation was in double digits, and when inflation was 6 per cent, and when oil prices were rising and close to their peak, and when the economy was booming. He also raised and cut rates when the economy was in recession. The close correspondence between the decline in inflation rates and the reduction in the FFR suggests that when you want to tame inflation, you focus on inflation, period.
The Volcker policy would mean that when CPI inflation in India rises by a significant amount (six months above 6 per cent), the RBI should raise rates. But right now, there is no argument, literally, for the Volcker RBI not to start cutting rates, and cutting aggressively. Unless the RBI does not  want to take lessons from the greatest inflation fighter of them all.

The writer is chairman of Oxus Investments, an emerging market advisory firm, and a senior advisor to Zyfin, a leading financial information company