Excessive monetary measures are best avoided in an uncertain world environment, where financial flows and political instability can alter the macroeconomic climate in a matter of months. Such policy moves take effect after a lag of at least six months, by which time the economy might require stimulation rather than restraint, says A. SRINIVAS.
All of a sudden, a dream has turned into a nightmare. In less than two years, a situation of high growth and subdued inflation has changed to one of high inflation and definite indications of a slowdown.
Hit by high commodity prices and rising credit costs, industry is showing signs of slowdown. The food price rise might be lower than core inflation rate of 10 per cent, but given the high prices right through 2007-08, even an increase of close to 7 pe r cent is cause for concern. The objective should be to restore the ideal combination of low inflation and high growth in double-quick time.
What’s wrong with inflation, if it is accompanied by high growth? India’s recent experience shows that inflation hurts the poor the most. The rate of poverty reduction between 1993-94 and 1999-2000 was marginal, prompting many to call the 1990s the lost decade in terms of poverty alleviation. In contrast, 1999-2000 to 2004-05 saw the poverty ratio drop from 33 per cent to 28 per cent.
One big difference between the two periods was the rate of inflation. With the bulk of India’s workforce in the unorganised sector, high inflation is bound to erode income and savings. If the economy-managers are serious about broadening the demand base and tapping micro-savings through an expanded bank and insurance network, inflation can upset their plans. However, the issue at hand is to arrest inflation without sacrificing growth and employment generation.
The current bout of double-digit inflation is different in character from what the country experienced last fiscal. Last year’s spurt was driven by food articles, with an appreciating rupee holding back core inflation. Foreign institutional funds have become net sellers since the start of 2008; this, alongside high oil and commodity prices worldwide, contributed to a slide in the rupee this year.
Oil prices were about $70 a barrel at this time last year, almost half the present level. The growth of hedge fund activity in all commodities in the aftermath of the sub-prime crisis had not reached current proportions. In short, the role of global forces in today’s inflation is more pronounced than in 2007-08.
The RBI has been responding to inflation with the same prescription of CRR and repo rate hikes for about a year, even as the circumstances have changed. While money supply and non-food credit continue to grow at an impressive clip, the fact of the matter is cost-push inflation poses a bigger threat than demand-pull inflation. By contributing to higher costs in a bid to curb money supply, the RBI may well be leading the country into a stagflation trap — a combination of unemployment and rising prices.
The theoretically inclined would call this a failure of monetarism: focusing on money supply to the exclusion of other factors and paying the price for it. Why didn’t policymakers foresee the changes in world financial patterns in the wake of the sub-prime crisis and identify rising costs as the bigger threat? Renowned economist John Kenneth Galbraith was always sceptical of the ability of central bankers to come up with the right remedy at the right time.
The Reserve Bank of India should not have used blunt monetary instruments over recent months to combat inflation. Interest rates were hardening anyway, thanks to a liquidity crunch. This has come about because financial flows have ebbed, as risks to business have increased in a situation of high input costs.
A 50 basis point hike in the repo rate — the rate at which banks borrow from the RBI — will force banks to hike their prime lending rates, especially when the market is no longer an attractive place to borrow. Similarly, the 50 basis point CRR hike will impound Rs 19,000 crore from the banking system, accentuating the liquidity crunch. In trying to reduce money supply growth from the current level of 22 per cent, as against the targeted 15-17 per cent, the RBI might have exacerbated conditions for cost-push inflation. If the global economy were to witness a slowdown, high costs could hit exports and nullify the benefits of the currently depreciating rupee.
Those who feel that higher rates of interest will attract capital flows, with the appreciating rupee taking care of the spiralling costs of crude imports, are mistaken. This has not happened in the recent past when the RBI resorted to rate hikes to tame inflation. A $3-billion cap on FII flows into debt effectively rules out significant interest rate arbitrage.
Excessive monetary measures are best avoided in an uncertain world environment, where financial flows and political instability can alter the macroeconomic climate in a matter of months. Such policy moves take effect after a lag of at least six months, by which time the economy might require stimulation rather than restraint.
Repeated CRR hikes have had no impact on the growth of non-food credit and money supply. This is perhaps because inflationary expectations, thanks to heated commodity markets all over the world, are forcing people to buy today what they might have put off for tomorrow. Unless the world outlook on inflation changes, the current pattern of expectations will remain, nullifying rate hikes.
There are indications that, buoyed by an expected 8.7 per cent increase in global wheat output in 2008, food prices will cool off. India might have a good year on the farm front. But how crude prices will go is anyone’s guess. If the US opts for a sudden strike in Iran, the prospects of which are not exactly remote, it could disrupt crude supplies in the short run and yet provide a stimulus to the world economy, as military operations often do.
Since all this is in the realm of crystal-ball gazing, the best way to tackle inflationary expectations is to take on speculators and hoarders within the country. Instead of focusing on money supply control per se, the RBI should investigate into the uses to which bank credit is being put. It showed the way nearly two years ago by tightening provisional norms for real-estate lending, instead of hiking rates across the board.
This approach not only spares the rest of the economy, but is right in principle because it punishes only those responsible for distortions. With elections in the air, intermediaries close to political parties may be making a quick buck. As in 1995, the last time when inflation was in double digits , general elections are a year away. So, inflation may not be as global a phenomenon as the Government might have us believe.
The importance of specific controls cannot be overemphasised at a time when the exercise of restraint in fiscal policy seems an unlikely prospect. Tackling both inflation and growth calls for a different approach — of calibrated fiscal and monetary moves, rather than pendulum swings between accommodation and restraint.
A. SRINIVAS
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