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Scrutiny
 
INFLATION: THE INDIAN WAY
Hire us Please, Pranabda
A Blanket Interest rate Hike will have The Worst Economic Impact in order to Curb Supply-side Inflation. It’s time The Finance Ministry took Micro and Macro Economics Revision Lessons from us
Issue Date - 03/02/2011
 
Honest! Perhaps there’s no other leader we appreciate more for energy filled speeches and excitement laden activities than Pranabda. From spunky bridge-building exercises with opposition parties to spinning off cocky rib-tickling humour at just the right moment, the dada from the Sabha has more energy jam-packed in him than a man doing triple doses of the thirty-plus concoction. But given that Pranabda has been excruciatingly busy fire-fighting all the ills that his party had conveniently refused to acknowledge for such a long time – from the telecom tangle to the Commonwealth calumny – his focus has clearly reduced on what the RBI is conjuring up quarter after quarter as an alleged solution for solving and resolving the inflation issue! Dada, it’s time you hired us, as what the RBI is peddling as the solution for inflation could surely be the final nail in the coffin for the party.

But more of that later; first, the facts. The overall inflation rate has fluctuated wildly in the last three months of 2010 at rates of 8.58%, 7.48% and 8.43% respectively. Food inflation reached 18.32% in December and 18.91% during the first week of January, 2011. While inflation in the manufacturing sector came down from 4.56% to 4.46% in December, prices of vegetables rose by 22.90% in December over the previous month. Onions became more expensive by 34.86% and potatoes became dearer by 16.29%. Fuel and power inflation, in turn, rose by 11.19%. And how has the RBI handled such stubborn price increases? Through an evidently contractionary monetary policy – RBI raised the interest rates (the repo – rate at which banks borrow from RBI – being key; currently at 6.25%) by six times last year. It plans to hike the rates further on January 25, 2011 (possibly by 25 basis points).

It’s clear that RBI, in its love for capitalist theory and ways American, continues toeing the exact line that drove US into an economic disaster. US has gone through inflation many times. Excessive government expenditure, oil price shock, and a contractionary monetary policy followed by Bernanke in the mid 2000s pushed the world into recession.

 
Coming back to India, the problem starts with the RBI data itself. Our country still considers the Wholesale Price Index (WPI) instead of the Consumer Price Index (CPI) to calculate the overall inflation rate. This means that inflation doesn’t reflect the consumer price of commodities at market rates. In essence, the general use of WPI is to measure the impact of price on businesses; yet, India uses the same to calculate the impact of prices on consumers. Also, WPI incorporates about 435 commodities with different individual weights, out of which many (like coarse grains) are not of much daily use today. Consider this: while general inflation rate was around 8%, food inflation touched 18% in December.

The second problem is RBI’s fetish for contractionary policies. As is well accepted globally, contractionary policies can work only when the inflation is a demand pull inflation (as raising interest rates and reducing money supply results in consumers having less disposable income, and taking lesser loans to purchase, say, houses). Unfortunately, food items in India are not of the luxuriant variety, which can undergo price jumps so suddenly and so uncontrollably simply because people have as suddenly and as uncontrollably started eating more – unless of course, as even World Bank head Robert Zoellick accepted this week, the inflation in India was much more due to supply side constraints. In such a case, tightening of monetary policy would end up destroying supply even further as businesses would stop investing.

So what should RBI do? Immediately initiate the practice of differential interest rates while providing money to borrowing banks, which would broadly mean three different interest rate slabs when the borrowing bank takes money – one, when the bank borrows money from RBI for providing loans to the agriculture sector, one for corporate sector and one for retail/end consumers. RBI should provide money to banks at lower rates (expansionary monetary policy) in case the banks are taking finances for subsequently providing loans to the agriculture or industrial sector. This will motivate supply growth. RBI should provide money to banks at higher or unchanged rates in case the banks are taking finances for providing loans to end consumers. This will proactively motivate savings and demotivate an increase in retail demand. At the same time, banks should be prohibited from charging increased interest rates from end consumers who have taken past loans. Protectionist surely; but when it is a question of the economy collapsing due to inflation rate jumps, a protectionist policy is any day more welcome than a contractionary one. Dada, try us out – one call and we’ll be at your service! And no, we’ll charge no interest for that.
Akram Hoque           

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