With the current spike in inflation, different views have emerged about the source of the inflationary pressures, their duration, and the appropriate policy response. A widely-held view argues that the source is only supply-led, the duration is likely to be short, and the RBI should focus on maintaining the growth momentum as it is largely helpless in countering the current bout of inflation. This article argues why these arguments are fallacious, why the seeds of the current bout of inflation lie in excessive demand, why the current spike in inflation is not a temporary spike, and why not raising interest rates now would risk unhinging expectations, potentially leading to a greater risk of a hard landing. | |
| There are several key indications that the economy still suffers from excess demand. First, the economy has grown significantly above its potential for the past three years. The stresses are showing up in excess demand for man-power, materials, and machines. Creaking infrastructure, high wage growth, and accelerating prices of basic metals, steel, cement, and other raw materials are symptoms of surplus demand. The argument that high investment rates signal capacity creation and higher potential growth is misleading because investment is a component of demand and supply takes a rather long time to create. |
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| Second, money supply has been growing at upwards of 20% for the past 15 months, significantly higher than envisaged by the central bank. Although some of the growth can be explained by financial deepening, the growth of money that is over and above the growth of nominal GDP over the past three years has been significantly higher than its 50-year and 10-year historical averages. When money growth remains so far above nominal GDP for so long, it affects the price level. In the long term it is the rate of growth of money that determines the price level. |
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| Third, interest rates in India are still not very high. With the current surge in inflation, real policy rates have been driven to below 1%, as against an average of 2% this decade. The benchmark repo rate still remains below bank deposit rates. Our financial conditions index, which combines interest rates, money supply, exchange rates, and the stock market, shows that financial conditions are still not too tight. With growth above potential, and inflation above target, any policy rule, a la Taylor, would call for further interest rate increases. |
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| Fourth, fiscal policy is becoming increasingly loose. An expansionary election-year Budget, coupled with a large wage increase for civil servants and further excise and duty cuts, will continue to impart a positive fiscal impulse and exacerbate inflationary pressures. With fiscal policy remaining loose, the onus of tightening will have to fall on monetary policy. |
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| Fifth, to the extent that there is a negative supply shock through higher import prices of food, fuel, and other commodities and given the structural bull phase in global commodity prices, these will eventually filter through to other prices as firms pass on increased costs of production to consumers. Firms are either increasing prices, or rather creatively cutting back on quantities in packets of biscuits, snacks, soap, and tea to sell at the same price. These increase the public's long-term inflationary expectations, which put additional upward pressures on inflation. Monetary policy needs to control these second-round effects through tightening. |
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| If the source of the problem is seen as excess demand, then the policy choices become apparent. Fiscal measures such as excise and customs duty cuts help in bringing down imported inflation, but they are one-time measures for an enduring problem. |
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| Exchange rate appreciation may be part of the solution because it reduces the imported component of inflation. However, given India's still relatively low trade linkages, it is inadequate to contain inflationary impulses from excess demand. Cash reserve ratio increases are a useful tool to impound liquidity, but they are a blunt instrument, and they penalise the banking system and do not convey the price signals that interest rates do. |
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| For all these reasons, the central bank needs to raise interest rates. By acting now and decisively to quell inflationary expectations, it would avoid having to clamp down through bigger rate increases in the future if expectations about inflation were to get entrenched. |
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| Some have argued that the central bank should not take account of commodity prices when setting policy as it is powerless to do anything about them. Yet, these "non-core" elements feed into headline inflation as argued above, and can keep it elevated for prolonged periods. When the inflationary components are food and fuel, which matter most for Indians, the RBI cannot merely sit on the sidelines and compromise on its primary objective "" price stability. |
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| The author is Vice-President, Asia Economics Research |
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