D. Murali and Kumar Shankar Roy

Chennai: Mr. Y V Reddy will not like this. The Reserve Bank of India has just hiked the cash reserve ratio, the amount of money banks keep with the central bank, by 0.5 per cent to suck out Rs 18,500-crore liquidity from the banking system. This has been professed as a measure to combat ballooning inflation. But an expert feels, RBI better stay away, at least for now. “The RBI should not intervene right now to manage inflation since monetary measures invoked to tackle inflation may adversely impact the growth prospects of the economy,” says Dr Shanto Ghosh, Principal Economist, Deloitte Haskins & Sells, Bangalore, during a recent Q&A interaction with Business Line, over the e-mail. Over to the economist…

What would be the top attributable reason for the inflation?

Before I get into the details of the sources of inflation, let me lay out up front that while the inflation rate moving up to 7 per cent is certainly something to be wary about, it is still well within the tolerable limits and certainly too early for us to start imagining a doomsday scenario. The media hype around this seems to be more of politics and less of economics!

Having said that, let me emphasise that the trade-off between growth and inflation is a well documented phenomenon – any country experiencing high growth generates a pressure on prices resulting from the higher income earned by individuals that benefit from the growth momentum. However, this aspect of inflation which is typically demand driven is not the primary cause for the current spate of inflation that we are experiencing in India.

The primary reason for the sudden increase in the general price level is more a manifestation of the inherent supply bottlenecks that are prevalent among key sectors of the economy as well as events characterising the global economy (e.g. higher crude oil prices).

We have invested far less than the required levels in improving agricultural productivity as a result of which this critical sector currently exhibits extremely low yields compared to other emerging economies. Moreover, export sops provided to agricultural products have diverted the required supply of key agricultural products (such as rice) from domestic to export markets.

Inefficiencies plaguing our Public Distribution System along with recent declines in manufacturing productivity have not helped in managing the pressure on prices. Add to this the RBI’s attempt to “buy” dollars in order to manage the exchange rate resulting in money being infused into the economy. This increase in money supply has added to the inflationary momentum set in motion due to supply constraints.

What are the measures that you see Government adopting to control inflation now?

First and foremost, political considerations aside, it is too early for us to start talking of contingency plans. I believe that the current inflationary spike is within the tolerable limits given the growth momentum that the economy is experiencing.

Second, fiscal measures that have been taken by the Government (such as barring exports of rice, reducing duty on edible oil imports, etc) are short term measures to ensure adequate supply. They are in the right direction (although there is some worry regarding the secondary impact of these controls on the prices of other commodities!)

I think the RBI should not intervene right now to manage inflation since monetary measures invoked to tackle inflation may adversely impact the growth prospects of the economy. As a long term policy measure, I do believe that the RBI should start moving towards a system of flexible exchange rates to regain its control on managing inflation.

Do you see a pattern in inflation spiking in the early months of the years? Or is it a one-off thing?

Just going by the data on monthly inflation, this pattern is not borne out. In 2004, average inflation rate in the first quarter of the year was around 5.5 per cent while for the rest of year it was around 7 per cent. This was true for 2006 as well (where first quarter average of 4 per cent was less than the rest of the year average of just over 5 per cent).

Is there any reason to expect such a spike in the first quarter of the year? Again, the answer is no. Prices of agricultural products is tied to the kharif harvest (typically done between August and September) while consumer durables are a function of seasonal demand patterns. Demand for consumer durables during the festive season usually dies down by the end of the year so demand-based pressure on commodity prices is unlikely to remain in the early part of the year. Hence, no systemic causal factors are present to warrant a prediction that inflation is likely to spike in the beginning of every year.

Is the Government to blame now for adopting short-term measures earlier?

If I recall correctly, inflation rates had gone up last in February of 2007 when the rate spiked to around 6.73 per cent led by a spurt in the prices of food products and some manufactured goods. In response to this price increase, the Government ordered state-run oil companies to cut gasoline and diesel prices. It also took measures to increase import of several food products and cut import duties on some manufactured goods. The central bank also took several steps to tighten money supply and counter inflation by slowing borrowing and spending. This did help in containing the rising price level and things settled down to 5 per cent levels in a short period of time.

Economists all agree that there are political considerations that come into play when prices rise beyond people’s expectations. All governments have been known to adopt short term measures to fight sudden changes in prices and adopt long term changes when the source of inflation is due to structural inefficiencies. Indeed, in India, the policy makers should be blamed for continuously ignoring the required lack of investment in improving agricultural productivity. The inadequacies that plague our Public Distribution System have also persisted over time. But there is little that the policy makers could do to manage the spiralling oil prices in the international market or address global supply bottlenecks in certain categories of our imports.

I do not believe that the current spike in inflation can be “blamed” on the Government failing to adopt long term policy measures when inflation reared its ugly head the last time around. Several international events and factors have also contributed to this inflation and these are, unfortunately, the price that we pay as India gets more integrated with the global economy.

There has been an across the board rise in prices. Right from grains, vegetables, fruits to meat etc. Is it the delayed effect of rise in fuel prices adopted some time ago?

There is a well established positive correlation between fuel prices and the prices of all categories of products. Currently, the international price of crude is hovering around $110 a barrel and is forecasted to reach over $140 a barrel in one year! Contrast this to the prices of under $28 a barrel in 2003 resulting in an average annual compounded growth rate of approximately 38 per cent between 2003 to the current period. Marry this with 8 to 9 per cent real growth rate exhibited by India and the increasing dependence on imported crude to sustain the various growth sectors of the economy.

It would be naïve not to expect this increase in fuel prices to have some flow through to the general price level in India. Of course, the maze of subsidies that exist in the oil sector in India makes it difficult to estimate the exact quantum of the impact.

I may also hasten to add that apart from the increase in fuel prices, short term supply constraints have also adversely impacted the prices – so the overall impact cannot be attributed on one primary source.

As an economist, do you feel the common man has a way to fight inflation? Or is it a losing battle as always?

Although inflation is a macro phenomenon, it is micro motives that eventually shape the macroeconomic dynamics of any system. It is very easy for me to say that the common man should not be swayed by irrational fears of impending price increases since that will result in a self-fulfilling prophecy of causing the very inflation that he feared. But unfortunately “herd behaviour” among consumers is far too common and impossible to predict or control.

Further, domestic inflation is not merely a demand driven phenomenon. International increase in crude oil prices, geopolitical events impacting supply of products and natural disasters and calamities are all factors that contribute to inflation. These are beyond the control of the common man and therefore his role is very limited in shaping the trend of prices in an economy.

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