The Hindu Business Line : The price of fighting inflation

The current high inflation has been fuelled by the rising prices of essential commodities, which people have to continue to buy, irrespective of the higher interest rates that may only reduce the demand for goods such as consumer durables. In such a situation, raising interest rates will only hurt economic growth without lowering inflation, argues NITYA NANDA.

GIVEN THAT THE current inflation is fuelled largely by the soaring prices of vegetables and foodgrains, tightening money supply by raising interest rates is unlikely to check it.

The issue of high inflation has been a cause of worry for the Government for quite some time. The Indian electorate has, historically, been quite sensitive to price rises. And the poor showing of the Congress in the recent Assembly elections has been attributed to high inflation in recent months. With Assembly elections in UP upon it, it is quite natural that the Government will take some urgent measures to contain inflation. However, even if one ignores the issue of electoral gains or losses, checking inflation is a social imperative as the poorer sections of the population are hurt more by rising prices.

The decision of the Reserve Bank of India (RBI) to tighten money supply by raising the interest rate as well as the Cash Reserve Ratio may, thus, have come as a shock to some, but was not entirely unexpected, considering the way the Government has tried to check inflation in the recent past. It could be shocking as the system is yet to get over the previous round of tightening by the RBI which, it seems, has not been able to do much to check inflation.

When high inflation hits the headlines last, it was also a time when crude oil prices were rising fast; now they have moderated a bit. Money supply was also tightened. Yet there is no sign of inflation coming down. One, therefore, may wonder if the current round of tightening of money supply will be able to deliver the results.

It is indeed difficult to consider the current round of inflation as being a case of `too much money chasing too few goods'. After all, people in India do not live as much on credit as they do in many developed countries. It is difficult to explain inflation in India as we currently see it as a monetary phenomenon. Even Milton Friedman, the father of the monetarist school, changed his views, to argue that `substantial inflation is always and everywhere a monetary phenomenon'.

Supply shocks

India is, however, not going though hyperinflation, though the current rate can be considered high. In fact, there is enough reason to believe that inflation is due to supply shocks, particularly of such primary commodities as foodgrains, vegetables and fruits, which are considered essential. This was only to be expected, as agriculture has been doing quite badly since the 1990s. This could be true, to some extent, even for manufactured goods, though industry is believed to be running at full capacity. Given this, the tightening of money supply by raising interest rates is unlikely to check inflation.

Since the current high level of inflation has been fuelled by rising prices of essential commodities, raising interest rates would hardly help as people will have to continue to buy them, irrespective of the higher interest rates.

Higher interest rates may reduce the demand for some manufactured goods, such as consumer durables — which people often buy through loans — and lower their prices. This might have some impact on the Wholesale Price Index (WPI). However, people don't feel the heat of inflation by the WPI. When prices of foodgrains, fruits, vegetables, milk and milk products continue to rise, what will it matter to the common people that prices of consumer durables stabilise or fall, as the latter are not items of daily consumption.

Worse, the non-availability of easy loans for buying consumer durables and homes may even induce consumers to spend more on non-durables. It is possible that those who have taken loans would try cut spending to service their loans, and those planning to take loans for buying homes may also cut spending to make the down-payment.

Higher interest rates can also hit the cash-strapped small producers, adding to the supply constraints, even in the short run, apart from affecting growth and investment in the medium term.

One should also not ignore the fact that the availability of cheap home loans in the past few years has reduced rental rates, bringing relief to large sections of population, particularly in the urban areas. While the real-estate services sector grew at 7.7 per cent during the 1980s, the figure has been just 5 per cent since the 1990s. Cheaper rentals may not be a part of the WPI and may not count as a factor in the official inflation rate, but they do matter for the common citizen.

Trade margins

One issue that has not been taken seriously is that the current inflation is not only the result of supply constraints but also that of higher trade margins.

Since the 1990s, wholesale and retail trade has been doing good business even when industry has not done so well, except in most recent years, and agriculture has done badly all along. Agricultural growth, which was 4.34 per cent in the 1980s, fell to 2.58 per cent during 1991-2005.

Similarly, the industrial growth rate also fell from 6.84 per cent to 5.83 per cent.

However, wholesale and retail trade, which clocked 5.9 per cent in the 1980s, saw a higher growth rate of 7.3 per cent in the 1990s and later. The question arises: If the goods in which they are trading have not grown much, how come their earnings are rising? The obvious answer could be the higher trade margins.

Even if one accepts that not all the growth in this sector is due to higher trade margins, as the country is exporting and importing more, or that higher trade margins could be justified because quality of service in this sector might have improved, the issue deserves better attention than it is receiving now.

To sum up, if the high inflation is due to supply constraints and structural problems, raising of interest rates will only hurt economic growth without lowering inflation.

(The author is a Fellow at The Energy and Resources Institute (TERI), New Delhi. E-mail: nitya@teri.res.in. The views are personal.)