In what is perhaps a sign that the government is now more concerned about the inflation threat than before, the chairman of the prime minister’s economic advisory council, C. Rangarajan, on Monday said the economy is mildly overheated and interest rates need to be increased to cool it down.
He was speaking at a meeting organized by the Bombay Chamber of Commerce And Industry.
While he said “the prospect of achieving a 9% rate of growth in a sustained way is within our grasp,” Rangarajan also asked industry to take rising interest rates into account when charting out their investment plans.
These comments by one of Prime Minister Manmohan Singh’s closest advisers are significant. Many observers believe that the government was initially less keen to increase interest rates than the Reserve Bank of India (RBI) was—and there has been speculation about a disagreement between the finance ministry and the central bank on the direction of interest rates. It is widely believed that the finance ministry is keen to protect growth while RBI is more concerned about price rises.
Statements such as the one Rangarajan made suggest that the government is coming around to the RBI’s view. “It now seems that the government swung from being sanguine about inflation to being panicky about it,” says a senior economist who has worked in government, and requested anonymity.
Rangarajan is an inflation hawk, and has often argued that there is no long-term trade-off between inflation and growth. He pointed out in his speech that rising inflation, the widening current account deficit and a 21%-plus growth in money supply are indicators of an overheated economy. “Inflation is at least 1% above acceptable levels,” he said, and added: “It cannot be denied that there are some signs of overheating. It is important that what is now a cyclical problem does not become a structural one.”
Rangarajan, who was RBI governor between 1992 and 1997, has been instrumental in introducing modern monetary policy in India. He is known for his low tolerance of inflation.
In the mid-1990s, Rangarajan had sharply pushed up interest rates to tackle an inflationary economy that was growing at over 7% a year. His critics say that it was RBI’s tight monetary policies at the time that pushed industry into a recession. In the course of his speech, Rangarajan defended his actions, saying that the downturn in the late 1990s was a result of the global economic slowdown that followed the Asian financial crisis of 1997 rather than high domestic interest rates.
In fact, Rangarajan also hinted in the course of his speech that RBI had pursued a very lax monetary policy in recent years. Low interest rates are one reason why consumer borrowing and asset prices have increased in recent years, say some economists. “Perhaps interest rates should not have been pushed so low. At one point of time, depositors did not get positive real returns on their savings,” said Rangarajan. That statement could be construed as a veiled criticism of RBI’s loose monetary policies in recent years.
But, said Rangarajan, “a consumption boom that continues for a long enough period of time can create the conditions for an investment boom.” He added: “Even as we tackle some of the consequences of cyclical overheating such as inflation, we need to pay attention to removing the structural bottlenecks that could develop as constraints on economic growth.”