India’s wholesale price inflation, at double digits, is partly imported—but not entirely. Money supply has grown too rapidly, the budget deficit is excessive and real interest rates are negative even after a recent Reserve Bank of India (RBI) rate rise. The traditional remedies that are needed will be unpopular, but the government can always blame US Federal Reserve chairman Ben Bernanke’s monetary policy.
Rising prices for imported commodities have played their part in pushing the inflation rate to 11.42% for the week ended 14 June, the highest since 1995. Food, fuel, metals and other primary commodities rose 14.8%, contributing 83% to headline inflation.
But most of India’s food is domestically produced. Its fiscal deficits in Central and local governments have increased, partly because of oil and food subsidies, and on a consolidated basis are nearing 10% of gross domestic product (GDP). The fiscal deficit for the Central and local governments in April and May totalled Rs73,200 crore, or more than half of the Rs1.33 trillion target for the year to March 2009 and about 9.2% of GDP for the period.
With money supply growth in the last year running about 7 percentage points faster than the 14% growth in nominal GDP and with real interest rates negative for close to two years, it is not surprising that India’s inflation is accelerating.
The solution to the problem is economically traditional. On 24 June, the central bank increased its repurchase rate, or the rate at which it infuses liquidity into the banking system, to 8.5% from 8.0% and decided to raise the portion of reserves commercial banks need to keep with RBI to 8.75% from 8.25% in two stages.
But RBI needs to raise interest rates from the current 8.5%, probably into a territory above 12%, where they will be positive in real terms.
The government should sharply reduce energy and food subsidies, which significantly worsen India’s already large fiscal deficit. And third, the fiscal deficit itself must also be cut, because in a period of tighter monetary policy, government spending would otherwise “crowd out” the private sector.
Such measures would be painful, but probably onlymoderately so. India’s economic growth rate was 8.8% in the last fiscal year, so a slowdown in growth doesn’t have to be disastrous. But it’s unlikely that India’s politicians will undertake such a deflationary programme, especially with the general election due by May 2009.
Still, if and when this or a future government does finally grasp the nettle, it will at least have an obvious scapegoat for its angry public—Ben Bernanke, who has pushed real US interest rates sharply negative and thereby contributed far more than India’s cautious central bank to the commodity inflation that has exacerbated India’s domestic problems.