The Hindu Business Line : Incomes, wealth jumps drive inflation

The pressure is unrelenting despite a series of interest rate hikes by the RBI. Inflation has advanced from four per cent levels to over 6.5 per cent in the last few months, causing disquiet in the Government, the central bank and financial markets (not to speak of the common man).

In a way, it should have been expected. The economy is growing at a torrid pace - in the range of 10 per cent per annum. A consumption and investment boom of the never-seen-before magnitude and type is there for all to see. In the circumstances, what would have surprised is the absence of inflation.

The dilemma - as always - is how to bring down inflation without jeopardising growth. Price stability, by itself, can be easily bought with a sufficiently tight monetary policy.

Any and all asset bubbles can be punctured with punitive interest rates. But is that all that we want? The answer is, clearly, no.

The challenge

Hence the challenge of finding the rate which satisfies growth and inflation goals together. No easy - some might say impossible - task.

Given globalisation and the dynamics, it is like trying to hit a fast-moving target which keeps changing its spots.

Nevertheless, there is a job to be done and governments and central banks exist to do it.

On the whole, in recent times, Indian policymakers have done a marvellous job in achieving the dream combination of maximum growth and low inflation. Is that now about to unravel?

The good news must be that goods inflation is not because of any major supply side shock. With our more than comfortable forex reserves, shortages can be `imported' away.

Meanwhile, it is necessary to increase domestic capacities. Free markets will make sure this happens and is already the case in large swathes of the economy. Today, we operate with far more degrees of freedom than in the last half a century.

Inflation, as any self-respecting central banker knows, is a lot about expectations and psychology.

Speculative demand, i.e. demand beyond consumption and normal inventory requirements, is fuelled if the (prospective) price rise is more than the interest rate. This is most apparent now in property where the cost of borrowed money is still far less than the rate of asset appreciation.

Right signals

The RBI is clearly (and rightly) sending the message that it will tighten rates and increase capital and provisioning requirements for banks' real estate exposures.

This should start having a price-sobering effect soon, given that such measures usually operate with a lagged effect.

Once the spiral of asset prices feeding into general inflation is arrested, the RBI can start breathing more easily. For, there is little doubt that it is the explosion in asset prices which is adding one or two percentage points to overall prices.

Jumps in incomes and, more important, wealth, dilute the price sensitivity and elasticity of demand and increase the pricing power of producers and middlemen.

This seems one of the proximate reasons for the current upsurge in inflation.

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