The Hindu Business Line : Monetary tightening at the cost of growth?

The main reasons for inflation are supply-side factors such as rising price of crude oil, commodity prices and food prices. A weakening dollar adds to the problem. In this situation, what will matter more are prudent fiscal, rather than monetary, measures.

Nilanjan Banik

It is no surprise that the central bank has come out with a tighter Credit Policy in a bid to contain inflation. The Reserve Bank of India increased the cash reserve ratio (CRR) by 25 basis points, from 8 per cent to 8.25 per cent. However, one should reason out the efficacy of such a policy measure.

Inflation happens when there is a mismatch between demand and supply. From a layman’s perspective, managing inflation is, therefore, taking care of the demand-side and the supply-side factors, or a combination of both. Demand-side factors constitute consumption expenditure, investment expenditure, government expenditure, and demand for exports and imports.

Hence, managing demand means managing any one of these components of demand, which will have an impact on controlling inflation.

For instance, the economic expansion of 2005 that lasted until the early part of 2007 was mainly because of an increase in such consumption expenditures.

A higher interest rate, which translated into higher loan rates, not only contained consumption expenditure but also investment expenditure, and thereby reduced inflation. Clearly, the tighter Credit Policy during April 2007 did contribute to reducing inflation rates from around 6.7 per cent to around 3.5 per cent within the quarter.

However, things are different now. The main reasons for inflation are supply-side factors such as the rising price of crude oil, commodity prices and food prices. A weakening dollar adds to the problem. Under the circumstances, what will matter more are prudent fiscal measures rather than monetary measures.

Exchange rates

The dollar as a currency is losing its value mainly on account of the sub-prime crisis in the US. The reason for the sub-prime crisis is that no one anticipated a fall in real-estate prices in the US, which have been declining by more than 30 per cent over the last two years.

As property prices follow a cyclical pattern it will actually be a while before the US economy, and, hence, the dollar, can come out of the sub-prime shock.

Crude oil story

Crude-oil is trading at an all-time high (around $120 a barrel). The reason is not demand supply mismatch in the oil sector but a weakening dollar.

Historically, there is an inverse relationship between crude oil and dollar prices. A rise in the price of universal input such as oil has lead to inflation, not only in India but also in other major economies such as China, the US and Russia.

In fact, inflation in Chian is now hovering around a historical high of 9 per cent. This supply-side inflation can be controlled by increasing the price of the dollar. It calls for a concerted effort by all central banks around the growing economies to lower the interest rates like is being done in India.

An rise in interest rate by increasing domestic foreign interest differential, will attract more foreign inflow and, hence, depreciate the dollar further.

Food prices

Globally, food prices have risen because of three main factors:

increased diversion of food items towards production of bio-diesel. The US, for instance, has diverted 20 per cent of its corn crop production towards ethanol production.

growth of Asia and Africa. Asia and Africa grew by around 9 and 6 per cent respectively against 2 per cent growth in Western Europe and North America.

vulnerability of agriculture production because of climate change-induced drought. Australia suffered from crop failure mainly because of global warming.

Other factors

Other factors such as a higher growth in money supply and imprudent fiscal measures such as the Pay Commission outgo can and will contribute to future inflation in India.

Money supply growth in India is currently above 21 per cent as against the targeted 17-18 per cent. Similarly, the Sixth Pay Commission, by putting more money into the system, will fuel inflation.

Under the present circumstances, what is called for is increased fiscal prudence by way of reduction in the prices of essential inputs such as iron and steel, cement, and controlling government expenditure such as a cap on pay hikes.

A tighter monetary policy, by sacrificing growth, might lead to stagflation (a combination of higher inflation and unemployment) — something none of us would like.

(The author is Associate Professor at the Institute for Financial Management and Research, Chennai. The views expressed are his own. nilbanik@gmail.com)