Inflation has remained at elevated levels despite eight rate increases of 25 basis points each by the Reserve Bank of India (RBI), subsequent to the reversal of its easy monetary stance in March 2010. The persistent high inflation can largely be attributed to its supply-driven nature, which cannot be effectively controlled through monetary policy. A tight monetary policy can, at best, control the transmission of surging food and commodity prices to other sectors of the economy by trimming demand. Although food inflation is now declining, non-food inflation is picking up.
This uptrend in core inflation (non-food manufacturing inflation) signals demand pressures on inflation. Rising wages and commodity prices too, are exerting pressure on prices and the cost of production. With inflation remaining high and becoming more generalised, the issue at hand is not whether interest rates should be raised, but rather by how much.
After a good show in 2010-11, the economy has now started to show signs of fatigue. Investment growth has slowed, while private consumption remains strong. The growth-moderating impact of rate increases in the past would continue through the current financial year. Accordingly, growth in private consumption demand would moderate in 2011-12, and most market participants expect growth in gross domestic product to decline in 2011-12 from 8.6 per cent in 2010-11. This should gradually curb the transmission of high input costs into final products. In this scenario, a shock treatment on the rate front may not be desirable. Instead, a calibrated rise of 25 basis points to reinforce the impact of past tightening would be far more appropriate. Needless to say, the fiscal deficit should be kept under control to complement RBI’s demand-moderating actions.
The writer is Chief Economist, Crisil Ltd
