Dr Subbarao's desperation

Central bankers, especially Governors, are not given to loose talk. So when Dr D. Subbarao, Governor of the Reserve Bank of India (RBI), said on Monday that the RBI was “desperate” to bring inflation under control, it is likely that he was telling the markets to be prepared for a rather large increase in the policy rates in about a week from now. How large remains to be seen, but one thing is clear: the baby-steps approach of 25 basis points at a time will no longer work. The question, of course, is whether strong measures will do the trick. Perhaps not. It would be an extreme act of faith to link vegetable prices — which are driving up the inflation rate — to monetary policy. All that will happen when the rates go up is a slowdown in the rate of industrial growth, which would have an impact on the current account deficit, now straining to touch four per cent of GDP. Even that, given the lags and leads, will take about 10 months to show up in lower inflation rates. It is also necessary to ask if higher policy rates would lower inflationary expectations. Again, probably not. So, for the rest of the year at least, it would be reasonable to expect inflation to remain high. It may, as some officials expect, come down to about 6.5 per cent by March in a statistical sense. But if food inflation remains at current levels or is even marginally lower, it may not. After all, summer, when prices tend to firm up, is not far away and, as far as the year as a whole is concerned, there is the monsoon to reckon with as well. If it misbehaves, the effects of higher interest rates will be pretty much offset.

As this newspaper has been pointing out for over a year now, the high growth of the last three years and the doles given out by the Government via the NREGS, have translated into higher incomes for everyone, not just the employed. This has increased the demand for food but, for structural reasons, agricultural supply has not kept pace. Add to that serious policy errors, such as allowing exports of some major items of consumption, not to mention the absence of a unified market for major agri-products, the field is set perfectly for speculation at the margin. It is probably this that has allowed small, temporary shortages to translate into disproportionately high price spikes. At the same time urbanisation, with its accompanying growth of restaurants to suit all pockets and the growth of the processed foods industry, has also contributed. Unlike in the case of household demand, the demand from these categories, even as a small fraction of household demand, is inelastic and therefore tends to influence prices. That the profits from such speculation accrue to the intermediaries does not necessarily mean hoarding.

What is needed is shock treatment. It will be interesting to see if the RBI's desperation extends to that.

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