The Hindu Business Line : Can inflationary pressures be ignored?

When central banks the world over are raising interest rates fearing inflation, the Reserve Bank of India has chosen to buck the trend, perhaps unwilling to dampen the rising business investments. This may benefit corporate houses but leave the under-privileged and less affluent sections wondering why the RBI is not playing the part of a competent referee, says T. C. A. Ramanujam.

Inflation is like toothpaste. Once it is out of the tube, it is hard to get it back in again.

— Karl Otto Pohl, former President, German Bundesbank

THE US Federal Reserve has hiked the interest rate to 4 per cent, the hike being the 12th in a series, and the highest in four years.

In the past two months, 10 central banks across the world have raised the interest rate. This is a favourite weapon to fight inflation. The US' inflation rate has doubled in the past year to 4.7 per cent, the highest since 1991.

The rise in inflation is now a worldwide phenomenon. It has risen from 1.1 per cent to 2.5 per cent in the UK and stands at 2.3 per cent in the G-7 countries.

Failure to raise the interest rate in keeping with the inflation rate would mean a fall in real interest rates. Both in the US and the Euro area, real interest rates are negative.

Most countries have been adopting a monetary policy that targets inflation. New Zealand's central bank has resorted to a rule-based strict monetary policy targeting inflation since1990, and so have the Bank of Canada, since 1991, and the Bank of England, since 1992. Twenty other central banks across the world are pursuing a similar inflation-targeting monetary policy.

The Fed and the Reserve Bank of India are exceptions to the general rule.

The Fed Chairman, Mr Alan Greenspan's successor, Mr Ben Bernanke, who will take over in February 2006, is one of the foremost monetary economists and a `hawk' at targeting inflation.

The latest theory

Monetary experts have now come round to the view that global forces are more important than domestic cost pressures in determining inflation in individual countries.

Higher oil prices, over which individual countries have no control, and the integration of emerging economies with the world market have curbed workers' bargaining powers to demand higher wages (The Economist, October 22, 2005).

It is argued that the nature of inflation has changed.

The truth, however, as The Economist points out, is that globalisation does not relieve central bankers of their responsibility of maintaining price stability. In fact, central banks should be vigilant about developments across national borders.

India's record

India's record in maintaining price stability over decades is commendable. From 1960 to 2000, developing nations and the Latin American countries experienced double-digit inflation, while India was able to maintain it at around 7.5 per cent.

Over the past half century, India's average rate of inflation has been modest (see Table). The emergence of new industrial giants, points out a former Fed Governor, Mr Don Kohn, has increased both global supply and demand for oil and other raw materials. The attempt in recent times to focus on core inflation by measuring consumer prices, excluding food and fuel, can be of limited academic value only.

Increases in the cost of any commodity can cause producers to raise prices, leading to higher wages, and the cumulative effect can lead to a cost-inflationary spiral that will be difficult to control. Cost and demand inflation cannot be viewed in different compartments; they are two ways of looking at the inflationary process as a whole. Excess demand can trigger inflation, and cost inflation will keep it going.

The real cost to the holders of money can rise when there is a loss of purchasing power during inflation — a phenomenon known to economists as inflation tax. The RBI has been managing money supply taking into account the needs of maintaining price stability.

In India, nominal interest rates are low now because of excess liquidity conditions emanating from the expansion of reserve money based on the accretion of foreign exchange reserves. The Government tries to tap such liquidity through stabilisation bonds. Any build up of inflationary expectations and any expansion of money supply can lower nominal and real interest rates further (Rangarajan, Economic and Political Weekly 2933, 2005).

RBI's interest rate policy

The decision of the RBI, in its Mid-Term Review of Monetary Policy, not to raise interest rates at this juncture can prove counter-productive. The current low interest rates favour large corporate houses. A substantial portion of bank loans to corporate customers (70 per cent) has been at sub-PLR rates.

The rates charged on loans to small industries and agriculture are far higher than that charged for corporate houses. It seems as though the less affluent sections are subsiding cheap credit for bigger borrowers.

Even the chairman of a nationalised bank has stated that the corporate sector was being subsided at the cost of other borrowers. At the same time, interest on deposit rates remained stagnant over the past two years. The real rate of return on deposits has been falling over the past two years, and it is the middle-class that suffers.

The RBI appears to be groping in the dark in its attempt to discover the rate of interest that would be compatible with a stable level of economic activity. There is an urgent need to look into the policy for making advances to the less affluent sections. About a third of the country's population lives on a per capita income of $1 a day.

In present conditions, when property and equity prices are soaring and business investment is picking up, the RBI's reluctance to raise the interest rate beyond 6 per cent can only be termed as erring on the side of caution. There is demand-driven inflation in the economy, and this is not only because of the oil price hike.

Statistical data can be misleading. Mervyn King, the Governor of the Bank of England, put it in a nutshell when he said: "Successful central bankers should be seen neither as heroes nor villains, but simply as competent referees, allowing the game to flow". Corporate houses may be pleased with the RBI's current policy of refusing to raise the interest rate, but the vast under-privileged lower middle-class and the less affluent parts of the community will not be able to see the RBI Governor as a hero.

(The author is a former Chief Commissioner of Income-Tax.)

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

Stories in this Section
Opening strategic windows

Farming options in a global village

Can inflationary pressures be ignored?

Is there a way to safely escrow our trust in governance?

Private hospitals

Basle II norms: Challenge and opportunity for Indian banks

FDI in retail: More benefits than costs

Rebuilding `Silicon Valley'