Milton Friedman said that at the end of day inflation is a monetary phenomenon. When supply of money exceeds available goods and services in the economy, prices rise and inflation accelerates. Incremental supply of money exceeding incremental supply of goods and services accelerates inflation.

Shyamal Banerjee/Mint

In India, the Reserve Bank of India (RBI) has multiple and conflicting objectives to manage. It has to manage inflation, growth, rupee and government of India’s borrowing programme. If RBI tries to lower inflation by raising rates, growth falters. If RBI tries to revive growth by cutting rates, rupee can depreciate. If RBI supports the borrowing programme, inflation can move higher. If RBI raises rates to defend the rupee, growth can suffer. Every action of RBI in managing one objective has some bearing on another objective.

If managing these conflicting objectives was not daunting enough, a parallel economy (which reduces the effectiveness of interest rate and liquidity adjustments) and occasional difference in the objectives of the fiscal and monetary policies (in a drought year, government of India is bound to open its purse, no matter what tightness high inflation may require) makes RBI’s job unique in the world.

A reasonable-sized parallel economy with access to the unorganized sector of financing reduces the effectiveness of the monetary policy. Whether you raise rates by 1% or 2%, it won’t make much difference to a person who is borrowing in an unorganized market. Whether you tighten liquidity in the banking system is not going to make much difference in a parallel economy where transactions are settled in cash, outside the ambit of the banking system.

In simple words, RBI is running a chariot where four horses of growth, inflation, currency and borrowing are tied in different directions. While one wheel of the chariot is that of a car, the other is that of a truck. RBI has to deftly manage the chariot on an uneven surface pulling strings in all directions to move the chariot.

We have been suffering from high inflation for some time now. In the initial phase, RBI responded by raising rates and tightening liquidity. Recently, they have responded by holding back on rate cuts in spite of demand for rate cuts from many constituents.

Unlike Western economies, where prices are adjusted for enhanced features (which helps in moderating inflation), India reports inflation numbers on an unadjusted basis (which sometimes pushes inflation to a higher level). We have our own issues in collection of data and accuracy of data but that’s a different issue altogether.

The US crisis of 2008 and the European crisis of 2011 (still running) along with the pressure of democracy has kept the fiscal policy at variance with the monetary policy. Increase in minimum support prices has kept food inflation at an elevated level. Sharp depreciation in rupee since last year, rebound in oil prices and a below-average monsoon (though improving) is likely to keep up the inflationary pressure in the near term. Slowdown in investments and high capacity utilization across many sectors does not bode well for inflationary expectation over the medium term.

The supply side has remained choked on account of many factors. Risk aversion on account of global uncertainties, nominally high interest rates and tight liquidity, execution delays on land acquisition, natural resource allocation and infrastructure bottlenecks, complacency of entrepreneurs from high margins, lack of equity capital, crowding out of private sector investment on account of higher fiscal deficit have all slowed down investments, resulting into lower capacity creation and lower supply.

Allocation of savings towards physical assets such as real estate and precious metal has reduced the availability of finance for investment in plant and machinery and supply creation. A tremendous wealth effect due to unprecedented appreciation in gold and real estate and expansion in money supply has kept demand at an elevated level in spite of slowing growth and rising prices.

Timely response by RBI in the form of tight liquidity and nominally higher interest rates have slowed down rising inflation but not brought it to a level where it can declare victory over inflation.

The classical economic solution for inflation at best is likely to provide short-term relief. Faster growth is uplifting millions of poor Indians. Wealth effect is increasing purchasing power for millions of Indians. They are going to demand more goods and services as they move up the income curve. Unless supply is created on an unprecedented scale like in China, it is difficult to contain inflation on a long-term basis. It is unlikely for the Indian democracy to create supply through ruthless execution like autocratic China did.

It seems that India is caught in a cycle where supply creation is not sufficient and demand pressure is unlikely to abate in a hurry keeping inflation at an elevated level for some time to come.

This is the first part of a two-part column on inflation by the writer. Nilesh Shah is director, Axis Direct.

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