Editorial: No free lunches

Then there is the problem of inflation. The text-book responses to this have one common feature: the short-term price for bringing down inflation is lower growth. There is no other way to bring down inflation in an environment of persistently high and rising energy and commodity prices. The statements that several government representatives have been making about growth not being impacted by the recent interest rate hikes are, therefore, misleading. They may be correct in arguing that the long-term or trend rate of growth will not be affected by the monetary stance, but that cannot be said about the immediate future. In fact, one could argue that timely policy responses, even though they will slow down the economy for a while, are the best way to preserve the underlying momentum in the economy. Greater confidence in the government's willingness to make the right choices translates into greater willingness to make long-term investments.

 

But confidence gets eroded when the government persists with the broad-based subsidy that is currently being provided, with enormous consequences for both the public sector oil marketing companies and the fiscal situation. In fact, the failure to accommodate the increase in global oil prices tends to aggravate their impact on the economy. Domestic consumption remains unchanged, leading to an expanding trade deficit, which in turn affects the exchange rate. Speaking of the exchange rate, of late the rupee has slipped lower, almost back to where it was when it began appreciating last March. The macro-economic situation suggests it should drop further, but there are those who argue that this is undesirable, because it makes imports more expensive, thus reinforcing inflationary pressures. Recommendations are made to reverse this trend and strengthen the rupee by selling foreign currencies from the country's reserves. Practically speaking, it is possible to defend the currency against depreciation for a while with this measure. However, if the underlying pressures on the balance of payments persist, the country could find itself on a slippery slope on which declining reserves lead to a loss of confidence in the currency and encourage people, both foreigners and residents, to take their money out of the country. Admittedly, this looks like a remote possibility with the current stash of over $300 billion in the RBI's kitty, but it would be hazardous to rule it out if policy were to remain gridlocked.Appreciating the rupee in these circumstances is another kettle of fish entirely. Market logic dictates that a currency should depreciate when the balance of payments turns negative, which it has done in recent weeks as a result of significant capital outflows. Artificially low fuel prices are, in fact, contributing to the rupee depreciation, thus making oil that much more expensive! All in all, the most sensible policy response would be to clearly define the priority economic (as distinct from political) objective and be transparent about what it would cost to achieve it.