Inflation has persisted for over 18 months and is currently in the region of 9 per cent on a year-on-year basis using the Wholesale Price Index (WPI). It was earlier felt that inflationary pressures would, on their own, moderate and all that monetary policy would have to do is take baby steps. In eight policy reviews since April 2010, the RBI undertook seven increases in the repo rate of 0.25 per cent each (on the eighth occasion there was no policy action).

When, in May 2011, the RBI raised the repo rate by 0.50 per cent, there was a broad-based agitation by borrowers (particularly India Inc.), bankers, analysts and the government that monetary policy would be disruptive to growth. In the June review, the RBI reverted to baby steps.

RELENTLESS INFLATION

There are two hazards to baby steps. First, taking inadequate doses of antibiotics over a prolonged period is not only ineffective, but makes the system immune. Secondly, political economy considerations and active lobbies restrict the window of opportunity for policy action.

There is strong advocacy for the view that inflation would dissipate on its own and that no policy action is called for. These expectations have been belied. Inflation has got out of hand and there is no way that it can be talked down by the authorities. The government now argues that anti-inflation measures are inevitable and some growth would have to be sacrificed. A dangerous line of thinking is that there is a new higher ‘normal' for inflation. Such an attitude is a standing invitation for social unrest. With the recent increase in petroleum prices, it is recognised that inflation would accelerate. Dr C. Rangarajan, the doyen among advisers to the government, has categorically stated that in July 2011, the inflation rate could reach 10 per cent and thereafter it would decline. The earlier ‘tolerable' rate of inflation of 5 per cent is no longer being talked about and inflation, at the end of March 2012, is projected at 6.5-7 per cent; there are some analysts who claim that a realistic projection for inflation at the end of March 2012 would be nearer 8.5 per cent.

What is particularly relevant is that official price indices understate the ‘true' level of inflation, which, at the present time in India could be as high as 15 per cent per annum. Such a high rate of inflation destroys the socio-economic fabric of the country. The inflation expectations survey by the RBI indicates that inflation would accelerate. While analysts are right in arguing that the government should bear a part of the burden of adjustment, the ground reality is that the central focus of the authorities is on matters other than economic and financial policies.

ONUS IS ON RBI

The historical experience is that when there are difficulties in governance, it is the central bank which holds up the rear. The media has been vociferous that further increases in interest rates will hit credit expansion and growth in the next 12-18 months. Despite talk about a lower pace of expansion of new projects, it is generally accepted that India can easily sustain an 8 per cent real rate of growth. India's growth rate is the second highest in the world, but the inflation rate is one of the highest among the emerging market economies. At the present time, inflation reflects a pressure cooker situation.

The genie of inflation is out of the bottle and suasion cannot be used to get it back in. It would be necessary to twist a few limbs and break a few bones before the genie of inflation gets back under the lid. If the authorities do not take action now, like a drug addiction, inflation will get strongly embedded in the system and the only option would be a cold turkey approach, which would be detrimental to long-term growth.

Accordingly, on July 26, 2011, the RBI should raise the repo rate from 7.5 per cent to 8.0 per cent. Furthermore, to ensure that monetary policy transmission is effective, the banks should be in deficit mode and accordingly, the cash reserve ratio (CRR) should be raised by at least 0.25 per cent to 6.25 per cent. These measures would be the minimum required for monetary correction.

The present repo rate is out of kilter with deposit rates, lending rates and government securities rates. In such a situation the RBI becomes a first recourse for accommodation rather than a lender of last resort. The RBI should take a leaf out of Chinese monetary policy, which has aggressively raised interest rates and reserve requirements even though inflation is much lower than in India. The RBI is in a Catch-22 situation. If it tightens monetary policy on July 26, 2011, it will be pilloried by vested interests. If it resorts to inaction it will be applauded today but will be condemned by history. The choices before the RBI are clear.

(The author is an economist. >blfeedback@thehindu.co.in )

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