Rate hikes do little to check inflation

Cheap policy rates will shore up sentiment

The US Federal Reserve’s deferring the tapering of its quantitative easing and the Reserve Bank of India’s offering a swap facility for forex deposits solicited from overseas Indians and bank borrowings against tier-I capital at a fixed swap rate, have resulted in better foreign inflows. While this has stabilised the rupee, which has  recovered sharply, the relief is only temporary. The underlying weakness needs long-term measures.

The inflation trajectory as marked by the wholesale price index (WPI) inflation firmed up in September 2013 as it notched up to a seven-month high of 6.46 per cent. Such an elevated level continues to be driven by food inflation, which rose to 18.40 per cent and reflects persistent supply-side bottlenecks. Perhaps that is the reason why monetary policy action like rate hikes has limited effect on the inflation. Experience shows 13 rate increases between April 2010 and October 2012 did not have the desired effect.

Inflation control can happen only through growth. Therefore, the long-term policy has to be to usher in cheap policy rates. This will shore up sentiments and revive the capex cycle. The improvement in supplies will ease the inflationary pressures.

The fear of negative real interest rates in such an event need not be a deterrent. Financial household savings are already down to seven per cent of the GDP and might no longer be interest rate-elastic. Likewise, the risk of flight of overseas capital can be mitigated through other steps for attracting flows. For example, 100 per cent foreign direct investment in more sectors, tax holidays, abolishing withholding tax, or extending the scope of fixed swaps.

Coming to another challenge, the sharp reduction in the current account deficit (CAD), impressive as it is, has resulted from the choking of gold imports. Again, this relief is temporary. Unless augmented and eventually replaced by more substantive measures, the deterrent import duties on gold will only see a flight to alternate channels (read smuggling).

A useful idea in this context is the introduction of a retail gold deposit scheme, which guarantees gold at a future date, say, after five years, but locks into the current gold price. Such a scheme will be CAD-positive and forex reserves-neutral. It will also drive financialisation of savings through additional deposits, and thus contribute to capital formation/GDP. (The author is former managing director, State Bank of India)