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Interest rates fixation

By Prem Shankar Jha DH 20-1-11

The RBI's measures to curb inflation has utterly failed. India has been suffering from highinflation rates throughout the past four years.

When the stock market greets the news of a huge slackening of industrial growth not with dismay

but unconcealed relief, it is a sure sign that all is not well in the Kingdom of Denmark. This iswhat it did on January 12: when the news broke that industrial growth had fallen to an 18-month

low of 2.7 per cent the sensex jumped up by 1.8 per cent.The reason for this apparent paradox is

not hard to discern. Industrialists are hoping that the sharp slackening of growth will make theReserve Bank of India reconsider its all-but-announced intention to raise interest rates yet again

for the seventh time since March to fight inflation.

The past six increases have already pushed up the basic cost of lending by 1.5 per cent. When,despite this, and despite the arrival of a bumper harvest, the end-of-year price data showed a

resurgence of inflation, driven by an 18.32 per cent rise in food prices, analysts concluded that

further hikes of up to 0.75 per cent during the course of 2011 were inevitable. Foreign investorssaw the writing on the wall and decided to book profits; many Indian investors followed suit, and

the next five days saw a drop in the sensex of almost 7 per cent.

Is an interest rate hike really necessary? Will it really bring down inflation? The RBIs next

policy announcement is due on January 25, so the government still has a week in which to reflect

upon these questions. But it doesnt need seven days because the answer has been staring us inthe face for the past four years. The RBI set out to curb inflation, then running at a little over 6

per cent by the wholesale price index, in 2006. But it has failed utterly and miserably to do so.

India has been suffering from high inflation rates throughout the past four years.

This inflation has been immune to the successive increases in interest rates, from January 2007

till September 2008, and again from March last year because, unlike previous bouts of inflation it

is not a demand pull, but a cost-push inflation, caused in our case by a shortage in the supply offood and imported raw materials whose prices have surged because of Chinas endless appetite

for growth. And one needs only basic economics to know that monetary policy cannot control

cost-push inflation.

The clinching proof that changes of demand do not affect cost-push inflation was provided by the

behaviour of prices during the global recession of 2008-9. Global demand fell, so the prices not

only of manufactures fell. This caused a drop in the prices of raw materials, including crude oil,of 50 to 70 per cent. The Indian market was no exception.

As a result the price of manufactures fell 7.6 per cent between March and December 2008 androse by only 2.85 per cent, under the spur of the fiscal stimulus package, during the same period

of 2009. But inflation did not slacken in India appreciably because the prices of foodgrains and

food articles continued to rise.

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As a result, prices of primary products rose by 5.2 per cent, of food articles by 8, and of fruits and

vegetables by 9.5 per cent. In the same months of the following year, when global demand was

still shrinking and Indian demand had just begun to stabilise the price of manufactures rose byonly 2.85 per cent, but those of food articles rose by 19 per cent and of fruits and vegetables by a

whopping 30.2 per cent.

The unexpected

Some analysts ascribed the rise in 2009 to the severe drought of that year, but 2010 saw the bestmonsoon in human memory, and the prospect of a bumper harvest. But instead of falling the

inflation rate climbed further on the back of a 42 per cent rise in food prices and a 49.9 per cent

rise in the prices of fruits and vegetables.

So why is the RBI continuing to flog the dead horse of interest rates? Its stock answer has been

that it is to curb inflationary expectations. But this is a Catch-22 answer because it cannot be

disproved. However, C Rangarajan, the chairman of the prime ministers economic advisory

council, has given a more plausible answer.

According to him, high food costs will harden the demand for increases in wages, and therebystoke inflation. The unstated corollary to his argument is that slowing down the growth of

output, reducing the growth of employment and forcing down the real wages of the working class

is not too high a price to pay for taming inflation. This is hardly likely to win the Congress any

friends.

Manmohan Singh, Pranab Mukherjee and S S Ahluwalia can hardly be unaware of this. But they

are comforting themselves with the view that thanks to the huge fiscal deficits of the past twoyears the economy has been showing signs of overheating. Thus there is a window open for

having ones cake and eating it at the same time, ie bringing down the rate of inflation and

bringing the economy back to a more sustainable growth trajectory. But a close look at theindustrial growth figures for the past 12 months shows that this is wishful thinking.

Although at 9.47 per cent industrial growth has been higher during the current fiscal year than itwas in 2009-10 (7.41 per cent) there has been a marked deceleration of growth after March, from

12 per cent in the first quarter, to 9 per cent in the second and 7 per cent in the first two months

of the third. Since the October figure of 11.29 per cent probably reflects the annual festive season

spending spree, it is likely that the December figures will depress the average for the third quartereven further.

An examination of industrial growth by sectors helps explain what is happening. Almost theentire growth in the past two years has been confined to capital goods and consumer durables.

The output of non-durable consumer goods many clothing, food products, beverages, and

tobacco fell from 7.3 per cent in April to November 2008 to 1.2 per cent in the same period of2009 and has fallen further to 0.7 per cent in 2010.

This reflects not only the phenomenal concentration of spending power that the so-called fiscal

stimulus created in the middle classes but also the decline in non-food consumption among the

poor as they struggle to meet the soaring cost of food. Another round of increases in interest rates

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will not contain the present cost-push inflation, but will only slow down industrial growth, and

further reduce the real incomes of the poor.

Time for baby steps

Monetary policy cannot kill inflation, must not kill growthBusiness Standard / New Delhi January 20, 2011 ( editorial)

The question of whether or not RBI should hike policy rates in its quarterly monetary policy

review due on January 25 should have been answered rather forcefully by the inflation data forDecember. After showing tentative signs of moderation in October and November, wholesale

price inflation shot up close to 8.5 per cent on the back of a spike in vegetable prices led by

onions and tomatoes. Even if these prices were to cool off a tad, the prospect of a hike in dieselprices looms on the horizon. The chances of ending the current fiscal year at anywhere near the

5.5 per cent that RBI officially targets seem bleak indeed. There is also a palpable sense of

despair and desperation in government agencies over its inability to tame the price monster.Thus, no agency that is even remotely associated with managing the price-line can afford to

remain passive at this juncture. The central bank in its avatar as the principal inflation-fighter in

the economy certainly cannot. A hike in policy rates thus seems inevitable.

However, another round of increases in interest rats is unlikely to bring the prices of food downin a hurry. Supply is clearly short for a number of food items, particularly things like milk, fish,

poultry and vegetables, and their prices have been rising steadily over the last two years. This

trend is unlikely to reverse unless there is a jump in farm productivity and a complete overhaulof their supply chain, and repeal of archaic marketing laws that impair competition in their

supply. This cannot happen overnight and households perhaps need to reconcile to the fact that

their budgets will remain strained in the foreseeable future. But this does not necessarily dilute

the case for further monetary action. For one, the very stubbornness in food inflation suggeststhat rising demand is also playing a role in keeping prices elevated. Besides, inflation

expectations are running high and this itself is playing a role in keeping prices sticky. Finally,

there is a risk of high food prices setting off second-round effects, particularly wage inflation thatwould feed into other sectors of the economy, transforming the rising food price into more broad

inflation. An increase in policy rates and its transmission to lending and borrowing rates can go a

long way in addressing these issues. The question then is: should RBI stick to its measuredapproach and push the reverse repo and repo rates up by a quarter of a percentage point or go the

whole hog and hike by half a percentage point? It might be tempting for the RBI governor to

choose the latter and signal to the markets that he too packs a mean punch. However, by doing

that he might just end up over-compensating for the other imbalances in the system that playan equally important role in keeping prices high excessively loose fiscal policy and the

woeful state of agriculture that years of neglect has bred. The result could be what economists

term hard landing or a sharp slowdown in growth. Growth has incidentally started lookingfragile again with the November industrial production index registering a growth of just 2.7 per

cent. The RBI governor has to keep the risk of pushing growth off a cliff in mind in deciding

Januarys policy action. A quarter of a percentage point increase in rates should do the trick thistime.

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