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Wednesday, December 9, 2009

Inflation Turns Positive

Much against the predictions of the pundits that as the impact of the base effect on inflation remains in force till end October, the year-on- year inflation shall continue to be in the negative zone till end September—the wholesale price index-based inflation turned positive, that too, well before the base effect wore off.

After remaining in the negative zone for the last 13 weeks, inflation has risen to 0.12% for the week ended September 5. Of course, it was not totally unanticipated: the surging food prices, coupled with the poor performance of the monsoon early in the season and the resulting speculation about the likely shortfall in production, have all cumulatively raised the index for primary food articles to 14.67% and that of manufactured food products to 9.21% from end March. As these two constitute 27% of the wholesale price index, it is no wonder that inflation has turned positive much earlier than anticipated.

That aside, with the governments across the globe propping up economies by resorting to massive deficits and central banks cutting interest rates substantially, many even touching zero, and the resultant revival of economies being reported from various parts of the globe, what is now more worrying is the prospect that the prices of manufactured products and commodities as well may rise faster than anticipated.

And, India is no exception to this phenomenon. The market borrowing program of the government has already been hiked to unprecedented levels since September 2008, and with the government’s gross market borrowing budgeted at Rs 4,51,093, it is all set to rise to gigantic proportions—an increase of 47% over 2008-09, on top of the 82% increase in the year 2008-09.

Indeed, the complexity of such a huge borrowing program becomes evident from what the Governor of the RBI said: “The increased fiscal deficit had raised the size of government borrowing significantly and that the RBI will endeavor to manage this as in the past in as non-disruptive a manner as possible.” Based on the analysis of the data from securities market and banking trends, it is argued that the successful completion of the government’s borrowing program warrants considerable monetary easing, if not monetization of the deficit.

Encouragingly, the government has made its intentions clear by announcing that it does not want to monetize the fiscal deficit. That the government borrowing has more than doubled just in two years should, in the normal course, lead to hardening of interest rates. But the ongoing active usage of open market operations by the RBI to enable a smooth and non-disruptive conduct of the borrowing program does not forebode such immediate hardening of interest rates. Now reverting to inflation, it must be admitted here that such a huge borrowing by the government does not augur well for containing inflation. This is what might have prompted even C Rangarajan to say: “The RBI particularly has to guard against inflation.”

Now, in a typical textbook-pattern reaction, the RBI may resort to monetary tightening. But one section of economists argue, and perhaps rightly, that with the growth in credit offtake languishing at 15%, as against 26% of last year, and the economy yet to be back on the high growth trajectory, it is not advisable for the central bank right now to hike the key policy rates. Secondly, it is argued that the experience of the nation tells us that the rising food prices had responded better to measures meant for improving its supply side logistics rather than the monetary policies of the RBI.

In the light of these arguments, many fear that monetary tightening may not be the right choice now to tame inflation. On the other hand, it may even prove to be counterproductive to credit growth and, in turn, to the revival of growth in economy. With huge government borrowings in the pipeline, it is already feared that it may result in ‘crowding out’ of investment.

The irony of the situation is that at the same time, the RBI cannot afford to be ignorant of the fact that with many parts of the world reporting improved economic performance, commodity prices are certain to harden. It must also bear in mind the surging inflows of foreign capital—both under FDI, which is expected to be $20 bn for the current year, and investment by FIIs in the stock market.

These conflicting demands—taming of inflation and simultaneously addressing the growth needs—are well set to challenge the wit of the RBI and its policies in the immediate future. One ‘quick-fix’ kind of solution is perhaps to revisit one of its earlier practices—imposing selective credit control measures. Imposition of sector-specific guidelines to banks in terms of high margins and increased interest rates can restrict the flow of credit to traders in food products and thereby eliminate speculative hoarding and trading. That may in the short run tame the inflation, or at least would not fan inflation further, while keeping the credit flow intact for investment and growth.

This time around, to successfully complete the government’s huge borrowing program that aims at providing stimulus to the economy without disrupting the markets, the RBI needs to be agile in timing its ‘exit strategy’—ascertaining whether growth “is a part of sustainable recovery” or an outcome of the short-term impact of the fiscal stimulus—and conduct itself in sync with the fiscal policies.
                                                                                                                   – grk


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