Inflation hawk

Raghuram Rajan wants to be India's Paul Volcker

Raghuram Rajan, India's new central bank chief, wants to be his country's Paul Volcker. The former Federal Reserve chairman's tight monetary policy tipped the US economy into recession in the early 1980s but succeeded in curbing double-digit inflation rates. Following in his footsteps, Rajan raised the monetary authority's key policy rate by 25 basis points on September 20.

Investors were shocked. Yes, inflation is high at 9.5 percent but GDP growth is collapsing. Strip out government consumption and real demand expanded only 1.4 per cent from a year earlier between April and June. Combating the Indian stagflation with higher interest rates will mean an even bigger sacrifice of output. Stocks fell as much as three per cent in Mumbai.

Yet, the central bank's focus on price stability is necessary. India's myriad state subsidies are inherently inflationary, as they pump cash into the economy without any commensurate increase in production. The federal budget deficit has reached 63 per cent of the fiscal-year target in just four months. Recently announced spending cuts are unlikely to be enough to reduce the deficit in a stagnant economy.

Then, there's the beleaguered rupee. To Rajan's credit, he is reversing the ill-conceived defence of the Indian currency mounted by predecessor Duvvuri Subbarao. Even while increasing the policy rate, Rajan cut by 75 basis points the penal rate the central bank charges liquidity-starved lenders which borrow directly from it.

Subbarao's decision to jack up this rate by 200 basis points was ineffective. The rupee slid 22 per cent against the dollar between May and August. The higher rates did, however, raise lenders' cost of financing long-term loans with short-term deposits and borrowings, effectively taxing a banking system already creaking under mounting bad loans.

Rajan can hardly take the success of his risky strategy for granted. The currency has stabilised for now but another rupee slump will push inflation even higher, by increasing the domestic cost of imported oil. And, how much higher can Indian interest rates go before Rajan's political masters stop him in his tracks? After all, they have to face an election next year. Rajan doesn't.