The Hindu Business Line : Will Reddy do a Volcker?

Despite several increases in interest rates and the cash reserve ratio (CRR), inflation hardly shows signs of behaving. It has become the despair of the Government and the Reserve Bank of India. Most are of the opinion that inflation news will get worse before it gets better.

So has conventional medicine failed? Is it time to try something different? More specifically, should we make the monetary policy much harsher?

For, hasn’t Milton Friedman said inflation is anywhere, everywhere and at all times a monetary phenomenon? If that is so, it is right to seek a monetarist solution.

Unfortunately (or fortunately depending on how you look at it), central banks around the world aren’t sure. The raising of interest rates, amidst a slowdown, risks throwing the baby out with the bathwater. Inflation isn’t out of control to justify punitive interest rates — at least not yet. Still, former US Fed Chairman Mr Paul Volcker is back in circulation (at least in print).

He was the one who drove up interest rates to the dizzy levels of 20 per cent in the early eighties. But he didn’t do this till inflation hit double digits. As of now, the US and Europe are far from that inflexion point.

But India is in the thick of double digit price rises. Should Reddy do a Volcker?

The answer clearly lies in the chances of a sharp rate hike being followed with immediate success in significantly bringing down inflation.

Assume that, for argument’s sake, the RBI turns the screws and pushes money rates to 15 per cent. (It can jack up the CRR sufficiently to achieve this). What’s likely to happen?

The first reaction of industry and trade would be to cut inventories. For, it makes sense to stock only if the rate of inflation exceeds the interest rate. Destocking transmits through the supply chain, affecting all intermediaries and producers in the supply chain. Pipeline inventory reduction by itself is probably worth some percentage points in the inflation rate. Final demand too would undoubtedly be significantly affected, having a further price softening effect.

There seems no escape from addressing a general inflation problem with a generally tight monetary policy — if inflation crosses the threshold of 10 per cent, the tougher the medicine the better. We are paying the price for not acting in time — keeping, for example, energy prices low even as they shot up globally and escalated our import bill; and compounding the crime with rupee appreciation not from current account strength but from capital flows.

Shock treatment might have to substitute for what might have been a gradual adjustment.

Paul Volcker cannot be far from Dr Y.V. Reddy’s thoughts.

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