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Tackling Inflation - RBI’s Failure

Posted in Finance Articles, Total Reads: 5009 , Published on February 26, 2012

Inflation is a demon that raises its head whenever a global economy grows at a break-neck speed. Managing inflation and growth has always been a tightrope walk for the central banks, an uncomfortable trade-off.

Tackling Inflation

From the basic AD-AS macroeconomic model, it can be understood that an increase in demand in an economy is equal to increase in supply side and increase in prices. This gives rise to two extremities-

  1. If the increase in demand is exactly met by a proportionate increase in supply, then there will be no price hike
  2. If there is increase in demand and the increase in supply is nil, entire effect of the rise will be reflected in the rise in prices or inflation

Most of the economies ( in case of growing AD and AS ) exhibit a scenario between the above two extremities.

In India , the rising inflation amidst the GDP growth rate of around 8.5% y-o-y was a major cause of concern for the RBI, India’s Central Bank. As a measure of inflation targeting, RBI went on a interest hiking spree. It changed its policy rates 13 times since October 2009. The result was the repo rates had gone up 350bps and CRR by 100bps. But inflation showed no signs of slowing down.

RBI’s Rationale

Overall price level in an economy is defined by the equilibrium of aggregate demand and aggregate supply. This was a blatant case of demand-pull inflation. Knowing that there exists an unavoidable trade-off between growth and inflation, RBI’s anti-inflationary stance relied on rising interest rates to curb aggregate demand. RBI thought the rising interest rates would have more effect in cooling down prices than on slowing the economy down.

The Unwanted Effect

Much to policy makers’ chagrin, as interest rates went northwards, the consumer spending and business investments fell considerably. The rising costs of borrowing amidst rising interest rates deterred the households and firms from spending. The rising rates continued to cast a negative spell on the financial markets as well. On the backdrop of dwindling consumer demand and willingness of the businesses to spend, industrial output fell by 5.1%, much worse than the expected 1% fall. The financial markets reacted, owing to untamed inflation, rising interest rates, shrinking industrial output and RBI’s policy failure, by pulling out capital from the Indian market. As a result the rupee hit  a new low in the exchange market against the dollar as it went past the Rs.50 mark. India, who runs a trade deficit faced an even bigger problem now. Rising demand for fuel and rising costs owing rupee depreciation led the government into an even more tighter spot. The price hike of gasoline due to the rising cost of imports further deterred consumer spending.

The Reason

The RBI after numerous rate hikes should have had a strong inkling that the inflation is not caused by the rising demand but by the inability of the supply to catch up with rising demand. India is a supply constrained economy. Manufacturing, infrastructure, power and in other few sectors India has displayed very sluggish growth. This sluggish growth and galloping demand in the economy allows the prices to go beyond control.

Recently, even though the food inflation dropped to a new low, a deeper analysis revealed that the inflation for protein-products ( milk, meat, eggs etc ) continued to be as high as 13% while the inflation for other goods like vegetables had dropped to extremely low levels. This was clearly created by the supply imbalances of these protein products. With rising incomes, affordability of protein-rich products of the consumers’ increased. But the supply channels were not efficient enough to handle the growth in demand and hence the inflation refused to drop for these products.

The Solution

Unfortunately the solution is not very simple. If rising interest rates did not work , does not mean lowering interest rates will work. 60% of the India’s GDP is contributed by domestic spending and dropping interest rates is only going to boost consumer spending. Given the supply side shortages that exist there would be an inevitable price rise again.

The devils of inorganic growth has eventually caught up with India. India’s growth has spawned from the growth of its service sector. Service sector forms more than half of the GDP. The lack of developed infrastructure and manufacturing ability is allowing the prices to go unrestrained amidst growing demand ( thanks to the booming service sector, which contributes to rising GDP and hence rising incomes ). The government should concentrate on building the core infrastructure of the country. The production capacity of the country has to be at par with the demand of the economy.

This article has been authored by Shovik Kar from MDI Gurgaon

Image: jscreationzs / FreeDigitalPhotos.net

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