Moving to high growth and low inflation

India’s GDP growth and inflation (based on wholesale price index) both are currently at 5 per cent. Growth slumped to a decadal low in 2012-13 whereas WPI inflation was at a three-and-a-half year low in April. In short, the combination is now at 5:5. Inflation is where we wanted it to be; the same is, of course, not true for growth. Seen another way, growth had to fall to 5 per cent to bring down inflation significantly.

The 5:5 combination is way off our aspiration in recent times to achieve 8:5–8 per cent growth with 5 per cent inflation. Achieving 8:5 remains a distant dream. Why is this so? And what needs to be done to get closer to a much desirable goal of 8:5?

Little room for tweaking

As per the latest data, GDP growth slowed to 4.8 per cent in January-March 2013, led by a continuous weakening in demand. Consequently, WPI inflation too fell below 5 per cent in April 2013. If we exclude prices of administered items such as diesel and foodgrains, WPI inflation turns out to be less than 4 per cent. As a result, there is now a dominant view that more space is available for the Reserve Bank of India (RBI) to reduce interest rates to lift growth.

What is the leeway available to lower interest rate, if we want to maintain WPI inflation around 5 per cent? Not much. If we want to maintain WPI inflation at current levels, and resist upward pressures as and when demand recovers, the economy’s productive capacity will have to be boosted. Otherwise, stimulating demand by only reducing interest rates could serve to spur inflation again.

As prices of key inputs such as electricity go up, a pass-through to consumers will be inevitable once demand recovers. This will be especially true, if following a good monsoon, household consumption picks up ahead of a rise in investments.

There is no evidence that monetary policy, by tolerating higher inflation, can engineer high, sustainable growth. Rather, faster but temporary growth may come at the cost of higher-than-desirable inflation, which itself will bedevil growth again. This is the reason the RBI has also reiterated that it does not have much space to reduce rates.

Sustained economic growth depends primarily not on interest rates but on real factors — on the availability of key inputs such as power, on regulatory policies that determine the incentive to invest, on the state of infrastructure such as roads and ports, on removing restrictions to job creation for plentiful unskilled labour, on raising availability of skilled labour, on productivity of sectors such as agriculture and services where most demand has to be met largely by domestic supply, and so on.

Supply-side factors

Factors such as availability of coal can lift growth instantaneously by allowing power plants to generate more electricity. Currently, an advertisement on television by a leading consumer durable brand tells potential buyers that its refrigerator can keep food fresh even during long hours of power cuts.

Clearly, companies believe that even urban households consider the availability of power while making a purchase decision.

Lower interest rates can’t influence any of the above supply-side factors much — they can’t increase power supply, or speed up project clearances, or raise the quality of our education system. Hence, the best way that monetary policy can aid growth is by keeping inflation stable — neither too low, nor too high.

This ensures that households and businesses do not have to worry about the extent of price rise when they take decisions on consumption and investment.

Therefore, to achieve the 8:5 combination — 8 per cent growth and 5 per cent inflation — supportive conditions to lift growth in other areas need to be created, rather than merely lower interest rates.

It is important that structural measures, which can oil the economy’s growth engines, are implemented as soon as possible. Only then can higher growth be maintained without it necessarily resulting in unduly high inflation.

During the economic boom between 2005-06 and 2007-08, the country reaped the benefits of many reforms implemented in the 1990s and early 2000s. These reforms had made the economic climate investor-friendly and improved the efficiency of the system.

Once again, it is time to create robust business-friendly conditions for long-term sustainable growth. Mounting pressure on monetary policy to lower interest rates significantly will not help the 8:5 cause. Rather, it may make that goal even more elusive.

(The author is Principal Economist, CRISIL. Views are personal)

COMMENT NOW