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Is India overheating? Eight myths about inflation
Kalpana Kochhar & Charles Kramer | May 12, 2007
Is the current inflation spiral primarily on account of agricultural shortages? Will the RBI's policy of raising interest rates kill the current expansion?
The pickup in headline inflation from about 4 per cent to over 6 per cent during the last 12 months, and the Reserve Bank of India's moves to rein it in, have sparked a vigorous debate in India. In our view, inflation is a problem - and the RBI has been correct in taking steps to bring it under control.
The debate has given rise to eight myths about inflation in India. It is useful to examine each of these myths so as to gain a clearer view of the issues - and the appropriate policy response.
It's all about food prices. Inflation stripped of food and energy, or other volatile components, is still rising. For example, between March 2006 and March 2007, year-on-year wholesale price index inflation excluding food and energy rose from 2 per cent to 7.9 per cent.
The pickup in inflation is all due to base effects from last year's low inflation. The notion is that depressed inflation in early 2006 exaggerates the rise in inflation during early 2007 on a year-on-year basis. But the three-month moving average of month-on-month, seasonally adjusted inflation has risen by about 3 percentage points over the past year - the same as year-on-year inflation.
Inflation will fall back to a normal range on its own. Leading indicators of inflation point one way: continued price pressures. Excess capacity has shrunk to a 14year low, according to the NCAER. In addition, there are signs of overheating in real estate and labour markets, with surveys showing the salaries of skilled workers rising by around 15 per cent annually.
Broad money growth has hardly slowed, still registering about 20 per cent year-on-year. With nominal GDP growing at about 14 per cent, this seems a classic case of too much money chasing too few goods - a recipe for inflation.
Fresh capacity will come onstream soon and alleviate constraints (or, what we really need are reforms to encourage supply). Investment and reforms are welcome - not just to combat inflation, but to generate growth and employment that can alleviate poverty and raise living standards. However, they take too long to come onstream to dampen inflation now. Indeed, inflation has risen despite double-digit growth in private fixed capital formation over 2002/03-2005/06, accompanied by an 8.5 percentage point rise in the ratio of overall investment to GDP.
Monetary tightening will kill the expansion. Keeping inflation under control, in fact, is key to sustaining the expansion. Waiting until inflation rises to higher levels will only make the job of stabilising prices harder. The international experience on this score is clear: When inflation expectations get entrenched at high levels, central banks have to tighten even more sharply to get inflation down.
Administrative measures are as good as - or better than - monetary tightening for controlling inflation. Some administrative measures can work against inflation control in the long run by discouraging supply. Banning exports and futures trading for selected commodities, for example, raises the cost of doing business and creates uncertainty about the regulatory environment. This can only discourage production, worsening supply constraints.
A stronger rupee does nothing to control inflation. A stronger rupee helps reduce inflation because it lowers the import prices of oil, other raw materials and capital goods and this, in turn, lowers the cost of production. It also reduces the prices of import-competing goods, like steel.
A related myth is that a strong rupee will kill the economy by hurting exporters. A stronger rupee does reduce the rupee value of export earnings - but it also reduces the cost of imported inputs, and to the extent that it dampens inflation, it limits the need for interest-rate hikes. Moreover, exporters are in a robust position now: as an earlier article in this newspaper pointed out, among 808 companies surveyed, net profits rose 67 percent in the October-December quarter.
Policy tightening will deny credit to small businesses and the common man, as well as hurt the poor. It is true that small businesses and the common man have only limited access to credit. This is a serious problem, but not one that can be solved through easy monetary policy.
The poor, meanwhile, not only have limited access to credit, but live on fixed incomes and have few or no assets to hedge against inflation - so that high inflation hurts them more than higher interest rates. Consistent with this idea, research by William Easterly and Stanley Fischer has shown that in a range of countries, higher inflation is associated with a lower share of national income accruing to the poor, a higher poverty rate, and a lower inflation-adjusted minimum wage.
In light of these realities, the RBI is right to have taken steps to rein in inflation. Compared with many other emerging countries, India has an admirable record of price stability. Maintaining this track record will pay benefits in terms of sustained growth with macroeconomic stability, and it will protect the most vulnerable Indians from the ravages of inflation.
Kalpana Kochhar is mission chief for India at the International Monetary Fund and Charles Kramer is a division chief responsible for the Indian economy.