Subir Gokarn: To act or not to act?

The best response to rising inflation is 'no response'

In hindsight, it is particularly surprising that inflation spurted when it did. International oil prices have been rising for quite a while now and it was only the suspension of retail price revisions prior to and during the election process that insulated the Indian consumer from this trend.

Steel prices, likewise, have been escalating sharply for the last three or four months, from an already firm base, having hardened over the preceding year or so.

To add to these global factors, the first half of the monsoon saw deficient rainfall, which would inevitably have an impact on the prices of some agricultural products.

As the domestic oil companies started to play catch-up on prices, the inflation numbers would inevitably have begun to reflect a more realistic and definitely more uncomfortable scenario.

Even so, the sudden spurt to first 7.5 per cent and then to a shade below 8 per cent, where the rate of inflation measured by the weekly numbers of the wholesale price index has been for the last couple of weeks, has shaken people.

Inflation is back on the political radar screen for the first time in many years, resulting in a visible mounting of pressure on the government to do something about it.

More specifically, there is a dramatic turnaround as far as expectations from the Reserve Bank of India are concerned.

For the last three years or so, the RBI has had the room to maintain a "soft bias" on interest rates. This has undoubtedly played a significant role in the industrial recovery, in progress since July 2002.

The last couple of half-yearly monetary policy announcements have seen a transition from "soft" to "neutral", but nothing to signal the kind of tightening that an anti-inflation stance would require.

As we approach the October announcement, the pressure to move in this direction is clearly mounting. Many people believe, and I am among those, that the last time the RBI took an explicit anti-inflation stance, towards the end of 1995, it contributed to the slowdown of the buoyant industrial sector then.

This time around, there is far less doubt about the causes of the inflationary pressure. It is predominantly cost-push inflation, caused by the adverse supply shock of higher prices of oil and other commodities and the temporary impact of a weak first-half monsoon.

Unfortunately, this certainty is precisely what puts the government and the RBI in a dilemma. There is really no effective policy instrument for cost-push inflation in the short term. Monetary compression works very well when inflation is caused by demand pull.

But, use the same approach in a cost-push scenario and you are virtually certain to precipitate stagflation""higher inflation accompanied by lower growth.

But, at the same time, can the government put itself in a situation in which it is accused of doing nothing while inflation rages?

The only thing that provides some relief in these circumstances is what the government has already done""reduce indirect taxes on the offending products, so that the cost to the consumer is brought down.

But, even though this may be the logical thing to do, its impact on inflation is limited by two factors. One, the initial level duties may not be all that high. Two, if prices continue to rise, the impact of the duty cuts can be neutralised pretty quickly. If crude prices keep going up, this is precisely the situation we will be in.

What, then, is the appropriate policy response? As politically incorrect as it may sound, the best response in these circumstances is "no response".

Long-run supply responses, such as reducing the oil-intensity of the economy and increasing productivity across the board, are what the system should be continually doing in any case, but they do not provide instant relief.

This episode highlights the fact that the international oil scenario can turn from benign to malignant in a matter of weeks and all oil-importing countries must reinforce their efforts to reduce their dependence. But, that apart, the government and the RBI must resist the pressure to engage in short-run measures merely because they must be seen to be doing something.

One factor that supports the "no response" position is the positive supply response from reserve-rich producers, particularly Saudi Arabia. It has perhaps been longer in coming than many people expected, but nobody really believed that it wouldn't happen sooner or later.

Virtually all forecasts see oil prices moderating to the low to mid 30s (US $ per barrel) by early next year. Even though this optimism has appeared increasingly hollow as the $40 plus levels persist week after week, experts have stuck to their moderate outlook.

Now, with the news of increasing production coming in from the Persian Gulf, despite the prevailing risks, the optimism appears vindicated. The pressure should ease in a few months and we should simply ride it out until it eases.

We should draw some comfort from the fact that, for the first time in our history we can actually afford to do this. Facing a similar external threat without the buffer that the $100 billion plus of forex reserves and 50 million tonnes of foodgrain stocks would obviously have been far more difficult, if not impossible.

Without the protection offered by these, the government would have been forced to act to conserve foreign exchange and ensure food security. Both these objectives would have required huge distortions by way of import controls and exchange rate manipulations.

Policy measures that are designed to deal with dire emergencies often impose significant long-term costs. When we can actually afford to do nothing, we must take full advantage of our situation.

In any case, while we wait for oil prices to ease, we can count on the good old "base effect" to take the spotlight off the inflation rate and ease the political pressure on the government and the RBI.

Last year, the inflation rate fell below 4 per cent during the weeks in which we are now observing rates close to 8 per cent. The low base of last year clearly contributed to the spike this year.

By the middle of August last year, the rate was at the beginning of a steady climb, going back above 4 per cent and crossing the 5 per cent mark in the third week of September. It reached a peak of 6.5 per cent during January 2004.

As long as oil prices do not increase significantly from now on, the base effect will cause the inflation rate to decline in the coming weeks.

The bottom line is that doing nothing is also a legitimate policy response; in the situation we are in, it is the optimal one.