The Hindu Business Line : Will monetary medicine lower the inflationary pressure?

The debate over the link between inflation and growth tends to remain inconclusive, and let not the RBI contemplate on any serious monetary contraction which is likely to stifle growth than contain inflation.

WILL INFLATION cross out growth?

The year 2006 saw the economy registering a significant growth rate and the boom in the stock market continuing. But it also saw the return of inflation in a more intensified fashion. In the official quarters, an annual inflation rate of 5 per cent is considered to be the threshold level, given the present structure of the economy. Hence, inflation becomes a cause for worry when it breaches the threshold limit. Since the current annual inflation rate is hovering around 7 per cent, the authorities cannot remain complacent and watch from the sidelines.

Since the Monetary Policy is largely forward-looking, the Reserve Bank of India announced a 50 basis points hike in the Cash Reserve Ratio on December 8, 2006, anticipating inflationary pressure. Despite the fact that the CRR hike would have impounded an additional Rs 13,500 crore of commercial banks' lendable resources, inflation crossed the tolerable level. The RBI's announcement of a 25 basis points hike in the repo rate in the recent third Quarterly Review of the Monetary Policy unambiguously signals that further monetary contractions cannot be ruled out so long as inflation stays above the threshold limit.

The crucial question is whether the monetary medicine is appropriate to control the current inflationary pressure? To answer this question, a look at the factors causing the inflationary pressure and the relevance of monetary instruments in controlling them.

Supply-side constraints

The reasons for the current inflationary pressure are many and varied. First, the petroleum price hike was blamed and later there was a belated recognition that supply-side constraints operating on primary goods, especially pulses and edible oil, were responsible for the price rise. Thus, the current inflationary pressure is basically due to supply constraints in select sectors and, hence, this sectoral inflation hardly reflects any monetary consequences.

The authorities have chosen to live and operate via the Monetary Policy instruments, perhaps by looking at a significant rise in the growth of M3 money and subscribing to the view that the economy has been over-heated. However, it should be remembered that a significant proportion of M3 money is commercial bank deposit that reflects growing credit disbursement that, in essence, lubricates the growth process in the economy.

In fact, fluctuations in output growth have largely been the cause for fluctuations in the growth of M3 money in the Indian monetary history; hence, higher monetary growth does not reflect the negligence of the RBI. When the current inflation is being triggered by a series of adverse supply shocks and passive response of the government in the form of poor supply management until recently, how can the RBI be held responsible for it?

If only the Commerce and Agriculture Ministries had taken a series of short- and long-term measures to augment the supply-side management, especially of the farm sector, the RBI would not find itself in an embarrassing situation, being asked to do what it is not supposed to under the present circumstances.

Moreover, there is ample empirical evidence to suggest that contractionary monetary shocks tend to have an enduring adverse impact on the manufacturing sector relative to the primary sector. Given the heterogeneous impact of the Monetary Policy, further tightening of the policy seems to be less useful in combating inflation, which is largely driven by prices of primary articles, and may put industrial growth in the reverse gear.

Caught in a bind

Now the authorities are caught in a Catch-22 situation. On the one hand, to ensure adequate supply of pulses and oilseeds (which have been in short supply for the past two decades) and other wage goods, Customs duty on them needs to be lowered to protect consumer interests. But this will upset the domestic producers/trading community that, indeed, wants protection to continue. To make matters worse, there is a bullish trend in the world edible oil market, to some extent propelled by the newly-generated bio-diesel demand. Furthermore, the commodity futures markets at home, in their quest for price discovery, are also unwittingly unleashing speculative forces in the market. Given that this wage good was taken out of the Public Distribution System nearly five years ago, the common man is caught in the vortex of the unknown with its own attendant political backlash for the ruling authorities.

While the solution lies in effective supply management via increased production and enhanced productivity in the oilseed and pulses sectors, it is not going to be easy in the short/medium-term to manage inflation caused by this structural transformation to the disadvantage of the economy.

Monetary contraction

Those who subscribe to the over-heating hypothesis tend to forget that China has been on a high growth trajectory for so long that it could not only live with a rigidly-fixed exchange rate with the dollar but also keep inflation rate within acceptable limits without any serious monetary contraction.

The debate over the link between inflation and growth tends to remain inconclusive and let not the RBI contemplate on any serious monetary contraction which is likely to stifle growth than contain inflation.

Fortunately, there is a good understanding between the RBI and the Finance Ministry and with all the self-imposed monetary discipline enshrined in the Fiscal Responsibility and Budget Management (FRBM) Act and under the guidance of the Prime Minister, the RBI and the Finance Ministry must take an integrated approach without solely looking through the monetary lens.

(M. Ramachandran is Professor, Department of Economics, Pondicherry University, and can be reached at ramchn2003@yahoo.co.in. D. Sambandhan is Professor and Head, Department of International Studies, Pondicherry University, and can be contacted at dsambandhan@rediffmail.com.)

More Stories on : Credit Policy | Economy

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Undeterred by inflation, Survey plumps for high growth

Micro-finance needs soft norms, tough monitoring

Set to soar

Today is the Day!

Is the RBI inflating India?

Why money must be gold-plated

`State' of the Union

Will monetary medicine lower the inflationary pressure?

Futures trading in farm products