Pulled by demand

Batten down the hatches? Pull out all the stops? It might be difficult to find the cliché that adequately emphasises the urgency with which the government needs to tackle inflation. The worry is not just that May inflation was in double digits (10.16 per cent). It is also a fact that prices of commodities other than food are now beginning to gallop. Inflation in non-food manufactured products (often referred to as core inflation) was 6.7 per cent in May, up from 6 per cent in March and 3.6 per cent in January. Non-core inflation actually declined in this period. Thus, inflation now seems to be in textbook territory where rising demand on the back of strong growth pulls up prices. It is no longer principally a supply-side problem driven by shortfall in food production. “Demand-pull” inflation has the nasty habit of embedding itself and feeding off growth. Its stubbornness makes it a much more difficult malaise to cure than supply-driven inflation. The data on the index of industrial production (IIP) for April, released just a couple of days before that on inflation, should dispel any doubts about the robustness of growth. Industrial growth for that month clocked a spectacular 17.6 per cent, a good two percentage points higher than even the most aggressive forecast. Thus, to cut a long story short, the government should lose some sleep over prices.

Textbook problems tend to have textbook solutions. If indeed excess demand is pushing up the price line, the remedy would be to try to put a lid on it. That is primarily the remit of monetary policy and the ball is now squarely in RBI’s court. The central bank needs to hike the so-called policy interest rates — the repo and reverse repo rates that set the level of overnight borrowing rates of banks and ultimately determine all other lending and borrowing rates in the economy. The question of whether this is likely to do the trick immediately is somewhat irrelevant. A majority of economists seem to think that the central bank is behind the curve in responding to rising prices and has been too distracted in chasing other goals like keeping the government’s borrowing costs low. Thus, the central bank must reaffirm its commitment to holding the price line and its willingness to jettison other targets that conflict with this objective. The signal that the monetary authority is in charge of the situation is itself likely to dampen inflation expectation and work at the margin to ease inflation. In the longer term, a calibrated increase in interest rates will help in moderating demand pressure. Could the rise in interest rates arrest the economic recovery? Industrial growth statistics for the January-April period (average IIP growth in this period was 15.8 per cent) suggest that the turn in the industrial cycle is well entrenched. They also show that the recovery is fairly broad-based and not riding on the backs of a handful of sectors. Investment activity seems to be picking up at a rapid pace (the capital goods component of the IIP increased by 73 per cent in April). A modest increase in interest rates is unlikely to take the fizz out of this entirely. What it will certainly thwart is the danger of an overheated economy that implodes later.