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What is the Cure of India's Inflation Problem?

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Inflation
 
 
Amol Agrawal, an Economist, discusses the reasons for the rising inflation in India and how it can be restrained to sustainable levels.

Amol Agrawal

Amol Agrawal is an Economist with STCI Primary Dealer Ltd. He also frequently blogs at Mostly Economics (http://mostlyeconomics.wordpress.com).

 

Muralidhar Rao Gopidalai speaks to him.

In India, high inflation is a big concern. How do you think Indian Government can rein in inflation to appropriate levels?

Inflation management is going to be very tough. It is going to be an issue which would be persistent for a while. There are both demand and supply side issues which are confronting the Indian inflation problem. On the one side, you have rising demand because of the growth and on the other side the supply factors have not kept pace. The rising demand and supply deficiencies in various sectors is leading to a rise in prices.

When you look at other countries like China, they have managed to keep inflation low during the high growth phase because supply was never really a problem. They always created additional capacities and it is only now when the global food prices have risen, inflation has become a problem in China. Unlike China, India has many supply-side issues and the result is this spiraling inflation.

The Indian Government’s policy should focus on increasing supplies. Tampering with demand would lead to lower growth. Over a medium to long term, we have to plan in such a way that the supplies are sufficient to keep pace with demand. In the short term, we have no other option but to soften demand through monetary tightening.

 

RBI has raised recently raised interest rates. Is that enough to control India’s inflation problem?

RBI can only control inflation which comes from demand factors. By raising interest rates it tries to lower money supply in the overall economy. This leads to an overall affect of lowering the demand in the country. Also monetary transmission takes a long time to materialize. The expectation that RBI’s rate hike of 50 bps would suddenly lower inflation is not possible.

Globally, central banks have kept interest rates very low. But banks didn’t lower the rates as much due to high risk and funding pressures. Monetary transmission has not been efficient in this crisis. We see similar situation in India as well. When RBI lowered rates in wake of crisis the rates did not come down as much. And now when it raised rates starting from March-10, it is only now the banks have followed.

In March 2011, RBI is expected to raise the interest rates again. RBI has been ahead of most other Central Banks by raising interest rates and doing away with the unconventional monetary policies put in place after the crisis in 2008. In India, inflation has become a structural problem rather than a cyclical problem. There are many factors responsible for inflation and monetary policy alone cannot solve the problem.

Since India started growing in 1990s, there is a problem of not achieving inclusive growth. As a result inequality has risen. We compare our macroeconomic indicators like GDP growth with peers from the BRIC nations. But on the social economic indicators, some of our peers are poor African countries. So the Government has started several social development programmes like NREGA etc. However, some Economists believe that these programmes actually increase aggregate demand and have stoked inflation. Hence, we have a problem of achieving inclusive growth and increasing the overall supplies which are already under pressure.

 

Is India’s Current Account Deficit an issue of concern?

Any deficit is a problem, whether fiscal or current account. If expenditures are more than income, obviously you are under stress. At a country level, persistent current and fiscal deficit is a major problem to the growth of an economy. As India is a developing economy, the expenditures may be higher than incomes. But the critical question is how are the expenditures being financed? If it is largely financed by the short term flows, then it is a reason to be worried. These sources can die anytime and so you are continuously under pressure.

The governance crisis, the inflation problem etc. further complicate the problem. Many developed countries like USA, UK, and Greece had deficits and now are under stress with deeper problems. In the past, the South East Asian and Latin American economies had faced similar problems. Suddenly there is one particular event that triggers a crisis resulting in the funds drying up and causing an economic collapse. It requires a very small event to trigger something bigger. So we can’t ignore any of these deficits. Markets don’t take persistent deficits kindly. They may be praising you for some time, but they may easily desert you.

The policy makers have to be cautious. I really don’t know how Current Account Deficit would affect us but it is emerging as a major risk. If the FIIs pull out funds in a short time, then managing the Current Account Deficit will be a major problem. The Current Account Deficit may not act as a trigger for a crisis but it can amplify when any crisis occurs.

 

What do you think about Federal Reserve's QE 2? How is it going to affect the Indian markets?

QE2 was the only option left for the Federal Reserve as nothing was really coming out from the fiscal policy end. The Congress was divided, and the Republicans didn’t support the fiscal measures. Unemployment figures were bad and policymakers took easing measures so that the economy doesn’t slump again. The US economy is not just huge but also has huge spillover effects on the world economy. Hence, whatever actions or measures are taken there affects the other parts of the world.

I am not sure whether this measure really helped the economy. There is a lot of debate among Researchers and Economists on whether the rise in the price of commodities was the result of QE2. The Federal Reserve has drawn a lot of criticism on the way it has handled the crisis and the way QE2 was done. In August 2007, the Fed Reserve said that the sub-prime crisis was not a major problem. But Bear Stearns happened in March 2008 followed by the collapse of Lehman Brothers in September 2008. No one was prepared for it and the Central Bank’s role in causing the crisis is not clear.

India faces some repercussions in terms of capital flows due to QE2. Interestingly prior to the crisis, a lot of policymakers were against capital controls. But now the same set of people is saying that capital controls aren’t that bad. A country can implement some policies so that asset markets don’t heat up. If this fails to control flows and there is a threat of an asset bubble, then capital controls are the final options in the hands of the policymakers. Economics is really a grey area with nothing in black or white. A policymaker’s job is always very tough.

 



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