The cost of fighting inflation

The cost of fighting inflation

Inflation at the current rate of 9% is clearly unacceptable. We now have a cry to tackle inflation on a “war footing". But every war has its casualties.

The most obvious casualty of a fight against inflation has to be growth. Macroeconomics 101 points out that there is a short- term trade-off between growth and price rise. To bring inflation down, growth must moderate. This realization is reflected in our current monetary policy stance. The Reserve Bank of India’s (RBI) relentless raising of policy rates, capped by the recent 50 basis points increase in the repo rate, is clearly geared to slowing growth. The massive fiscal compression promised in the budget—a reduction in the fiscal deficit from 5.1% in 2010–11 to 4.6% in 2011-12— should also, prima facie, lead to slower expansion. However, this reduction is itself premised on a 9% gross domestic product (GDP) growth rate.

The government’s initial reluctance to compromise on growth is understandable. Tax revenues, for one, depend on growth; deceleration is likely to hurt this. Also, sizeable divestments in public sector undertakings have been lined up to finance the fiscal gap (Rs 40,000 crore budgeted for 2011-12), and slow growth could hurt their profits and the ability to sell them at attractive prices.

In short, slower growth puts pressure on fiscal targets. This would be aggravated by the probability of higher oil prices not being passed on to the consumer. Policies, therefore, need to urgently tackle the fiscal deficit. The high deficit not only contributes to inflation, but is also a major reason for the long-term debt market not developing.

Which is the lesser evil in this trade-off—high inflation or unmet fiscal targets? At this stage, inflation has to get priority. If the consequence is slippage in fiscal targets, we will all have to learn to live with it. In fact, dealing with inflation will have to rely on a combination of demand and supply management. The latter could involve cutting import tariffs (or even excise duties) on goods that are in short supply. This could mean a further draft on government revenue, and fiscal ratios that are higher than targeted. This is the collateral damage of the war against the price-line.

Second, despite the best efforts of our policymakers, inflation is unlikely to fall in a hurry. The current bout of inflation is the result of domestic imbalances and the rise in global commodity prices, led by oil. There is a limit to which domestic policy can curb these conditions. Unless world commodity prices cool, we are unlikely to see the 5-5.5% levels of inflation that has been RBI’s tolerance limit in the past.

Finally, given the nature of inflation, it is perhaps unfair to expect RBI alone to fight it. For one, we must recognize that monetary policy works by affecting the cost of credit; high rates rein in demand by reducing the demand for credit. In a substantially underleveraged economy like India, where large swathes are outside the formal financial system, the efficacy of monetary policy alone in reining in prices is debatable. Also, inflation today is a consequence of both demand and supply pressures. It, therefore, requires a combination of monetary and fiscal policy.

There are a number of supply constraints that we need to remove. The supply chain in agriculture, for instance, has to be revamped if we are to make a serious, sustained impact on food inflation. We need to overhaul our educational institutions to ensure a supply of skilled labour. In the more immediate future, the role of large scale cash transfers through public works programmes in triggering a wage spiral and increasing the cash economy (substantial increase in currency in circulation) has to be assessed carefully; so too the possibility of lowering import/excise duties on commodities subject to short supply/rising prices. All this is outside RBI’s remit, and the government will have to step forward.

A quick series of rate hikes can indeed pull inflation back to the 5.5% region. But the risk would be an irreparable damage to investment, breeding severe supply shortages and killing the consumption momentum.

The world today is in a temporary state of buoyancy, which has caused a spike in commodity and oil prices, and is expected to slow later this year. This would lead to a more rational pricing of commodities through lower demand and speculation. Therefore, some monetary and fiscal tightening is a must. But an attempt to suppress inflation at any cost could increase long-term inflation risks by creating new imbalances between demand and supply.

There is enough evidence to show that high inflation hinders long-term growth prospects. Accepting higher inflation for the sake of the short term will lead to a situation where prices remain high and long-term growth is damaged. The attractiveness of the long-term India growth—its favourable demographics, entrepreneurial talent, high consumption content in GDP, high saving rate, strong banking system and so on—is robust enough to ensure that a couple of years of 8% growth will not really matter.

Aditya Puri is managing director of HDFC Bank

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