Difficult choices

The alarm bells have been ringing for the last few days as the inflation rate, measured by the Wholesale Price Index (WPI), touched the 7 per cent mark for the week ended March 22. The stock market landed with another bump, bonds did the same because of fears that the Reserve Bank would tighten liquidity and/or jack up interest rates, and the government was in overdrive because 7 per cent represents a threshold tolerance limit for the system as a whole. The government has already reduced customs duty rates on edible oils, persuaded steel producers to hold their price lines for a while and imposed restrictions on the export of various commodities. While nobody can fault the government for its very visible responses to a development that poses a political threat, it is important to view the inflationary pattern in a broader macro-economic context. Policy responses inevitably have an impact on indicators other than the one they are meant to deal with, sometimes favourable, sometimes adverse. Recognising and minimising potential trade-offs is something to which policymakers should give a high priority.

Important in any calculus is the over-all economic tempo. Last month, the index of industrial production (IIP) showed a sharp decline in its growth rate, at barely 5 per cent in January. While the decline was consistent with the widespread expectation of a slowdown, there are indications that the February numbers, due on Friday, will reverse course. The index for six infrastructure sectors, a subset of the IIP, showed a surge in February and almost doubled its rather sluggish January growth rate. While this sub-index has not been closely correlated with the broader index for some time, such a sharp reversal could well be reflected in this week's IIP data. If this happens, the monetary policy choice is more likely to be in favour of liquidity tightening and an interest rate hike, on or before the scheduled quarterly announcement on April 29.

The second important piece of data released last week was for foreign trade, which showed exports growing by over 30 per cent in dollar terms during February. This reinforces the acceleration that has been seen in recent months, following the mild slowdown in the aftermath of the sharp appreciation of the rupee last year. If this is a broad-based acceleration, it will add to the evidence that slower growth may not be as significant a risk as previously believed. However, it is also likely that the very commodities that are driving the inflation rate "" minerals, particularly iron ore "" may also be responsible for the growth in exports in value terms, because their international prices have risen so sharply in recent weeks. If this is the case and exports of important manufactured products remain sluggish, the policy dilemma of choosing between growth and inflation remains.

Ultimately, some combination of monetary, fiscal, trade and regulatory measures is necessary. A high inflation rate imposes a social burden, and bringing it down as quickly as possible should be the government's priority. However, the most effective response is going to be that which minimises the risk of adverse outcomes on growth and the damage that can be done to market mechanisms and, consequently, on future investment levels in key sectors. Finding the right balance between multiple instruments requires both internal co-ordination and clear communication to the public. Without these, the best-laid plans will come unstuck.