Rajeev Malik: Time to smell the coffee

A curious feature of the current debate over the rise in inflation is the difference in how development economists and financial market economists approach it in designing policy responses.

Simply put, the former look at inflation mainly through the lens of supply constraints and recommend eliminating these rather than raising interest rates to lower inflation. The latter emphasise that most supply constraints cannot be tackled over the near-term and hence suggest using monetary (and to the extent possible, fiscal) policy to check inflation and inflation expectations.

Reality, however, tends to be more complicated in a developing economy like India, which is undergoing tectonic structural changes. Inflation here is more likely to be a function of both supply and demand factors. Still, over the near-term, most supply constraints cannot be eliminated or even substantially reduced, leaving policy makers to deal with increasing demand and near-fixed supply.

Unfortunately, some development economists take their argument to an extreme. Thus, the capacity constraints in manufacturing, the surge in property prices and the rapid increase in wage growth are all supposed to derive from supply constraints and don't warrant near-term demand management. The policy prescription offered is this: avoid raising interest rates and work to eliminate the supply impediments, and the inflation problem will be solved.

Politicians, of course, are quick to lap up the supply-side angle on inflation, as it gives them ammunition to pressure central banks against tightening policy. And we have a perverse case study of aggregate demand increasing in anticipation of the eventual easing of supply constraints, rather than demand expanding at a pace set by the supply constraints.

To be fair, broader and deeper cuts in import duties and additional economic reforms over time will have a significant disinflationary impact on headline inflation. But the timing and shape of the policy response to unlock that potential, and the nature of the likely impact remain uncertain, and clarity on both counts is an important input in forming financial markets' expectations.

The key problem is that in the near-term, precious little can be done about most supply constraints. To the extent there are substitutes available overseas, food items could be imported. But the majority of issues like capacity utilisation rates and wage inflation can only be tackled in the near-term by affecting their demand. Of course, policy should adjust to capacity expansion and the easing of other supply limitations.

But alas, demand management is alien to the Indian policymaking psyche. We have historically focused predominantly on the supply-side, and even here we have not met the grade. Further, open economy macroeconomic analysis to gauge the pulse of the economy to track financial markets' response and their feedback is a new and evolving field. Combining the two gives us the practically scary result of the doyens of supply constraints championing their cause without appreciating the working of financial markets.

We have to shed our inhibitions about demand management. Monetary policy will emerge as a more important and effective tool for managing aggregate demand and inflation expectations, and in the process give rise to business cycles, which we have not been very used to.

The bottom line is that the speed of any vehicle has to partly be a function of the road conditions. Development economists would have you ignore the speedometer and instead fantasise about excellent roads. Such a delusional approach can only be a recipe for an unwarranted accident.

The writer is Executive Director and Senior Economist at JP Morgan Chase Bank, Singapore. The views expressed are personal