The Hindu Business Line : `Wealth Effect' complicates monetary Policy

Growth and inflation. Are they mutually contradictory? Can growth be maximised without stirring up inflation? What is the right mix of interest rates and liquidity for a desired combination of growth and inflation?

In the Indian context, an important realisation in recent times is that tiny increases in interest rates have no impact. Such is the economic momentum that the rise from 4.5 per cent to 7.5 per cent in the RBI's benchmark rate in the last three years did not dent growth at all — it actually accelerated.

Profits of frontline companies have skyrocketed and returns of 25 per cent and much more on capital are common. Stock prices have shot up in tandem with and beyond corporate performance.

Real estate in Indian metros is among the most expensive in the world — this in one of the poorest countries in the world on a per capita income comparison. Unsurprisingly, lending for real estate and property development dominates bank credit, given the yawning gap between capital appreciation and interest rates.

The boom is fed by and feeds on inflows from foreigners and Indians abroad. Year after year, in the last five years, the Indian market has delivered stellar profits.

Reddy's worry

This creation of enormous paper wealth, practically overnight, is qualitatively and quantitatively far more important than the GDP, its growth rate or sectoral components — in short the real economy.

Wealth — or the feeling of being wealthy — has more effects on spending and saving than income. But bubbles have a nasty habit of imploding severely and unexpectedly. It's a fair bet and guess that it's not the price of sugar, dal or edible oil which keeps Dr Y.V. Reddy awake at night but runaway asset price inflation and the consequences of an asset price collapse.

What, in the circumstances, is a central bank to do? It is uncharted territory not only for the RBI but every G-7 monetary authority. Raise interest rates punitively and the real economy could be damaged.

Amidst the policy knot, the good news must be that inflation in the normally understood and measured sense is hardly likely to spin out of control given the quick and strong supply side responses in today's global economy and markets. Also the interest rate moves of the RBI and in the bond market are too small to affect project investments, given their attractive profitability.

The central bank's hope must be that a sudden and sharp fall in asset prices does not hit banks' credit portfolios, constrain their lending and doom the rest of the economy.

The RBI is doing its job well. Its critics are best advised to add their prayers too for a soft landing.

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