The Hindu Business Line : Inflation and growth

In the short run, the country may have to live with inflation, but as policymakers are never tired of reminding the nation, the best antidote to all ills is growth itself.

As if the slowdown in industrial production were not bad enough, the economy has suffered another setback. The Wholesale Price Index that had breached the tolerance level of five per cent barely a week ago has moved to six per cent, setting a 10-month high. The sharp increase of nearly a percentage point so rapidly was occasioned by spikes in cereals, milk, vegetables and dairy products; prices of iron and steel; cement too zoomed significantly. With declining industrial p roduction pushing down growth forecasts and higher prices pulling the WPI upwards, what should the policy response be?

Much depends on locating the sources of rising prices and declining output. It is clear that the current price spiral is the result of supply shortages and not the consequence of an overheated economy. So, it is not a function of excess demand that was considered the basis for the RBI’s interest rate spikes in the first instance. On the contrary, demand is cooling, enough to pull overall growth forecasts down one per cent from the high of 9 per cent in 2006-07. Under the circumstances, policy-makers must address two distinct issues — fiscal and investment policies have to boost farm production and, in turn, food supplies; given the high global prices, increasing imports would only stoke inflation. In the short run, the country may have to live with inflation, but as policymakers are never tired of reminding the nation, the best antidote to all ills is growth itself. Policy should simultaneously focus on the main driver of growth — consumption demand– which has been trailing investment growth. Data to January 2008 show bank preference for government bonds over credit disbursals despite increased liquidity. For their part, potential new borrowers are staying put, given the sticky real estate prices and, of course, high interest rates, a tendency reflected in the declining growth rate of home loans. The Finance Ministry has done its bit this Budget in releasing spending power through the farm loan waiver and changes in direct and indirect taxes. Now, the RBI should reduce interest rates to have the most direct effect on spending.

Five weeks from now, the RBI will put out its monetary policy for the new fiscal. Two concerns will vie for attention: Rising inflation and falling growth. Chances are the central bank will focus on inflation and either hike interest rates or, at any rate, not reduce them. The first would be foolish and the second unwise. Monetary policy can do little against supply-constrained inflation. But it can do a lot stimulate growth that appears demand-constrained.

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