Editorial: Looking beyond 11%

Is suppressing inflation the answer to an underlying problem, or is it better to bring the problem to the surface as the first step towards addressing its causes and effects? Everyone who is shocked by the 11 per cent rate of inflation (as measured by the wholesale price index) for the week ending June 7, needs to figure out whether the problem is the figure of 11 per cent (the highest in 13 years...) or the ways to address macro-economic policy in an inherently inflationary situation. Everyone""from the stock markets to political parties to even economic commentators""is reacting as though a new problem has cropped up, when all that has happened is that an underlying problem has been brought to the surface. If the government had continued to suppress fuel prices instead of raising them in the week of June 7, the inflation rate would have continued to be in single digits""but that would hardly have helped matters. Admittedly, the 11 per cent figure is way above the comfort zone (which, until the current inflationary bout, used to be considered as having an upper limit of 5 per cent). But the only way to address the problem of rising commodity (including oil) prices is to make consumers pay the full cost. This will help contain demand as consumers adjust to the higher prices, and thus bring about the required re-balancing of supply and demand. Indeed, the shock value of the 11 per cent figure means that the government will simply not raise fuel prices further, irrespective of its cost. This is hardly a sensible way to go.

 

If the government made a mistake, it was in not anticipating the sudden jump in the inflation rate, and preparing the ground before the news broke. As it happens, most forecasts of inflation had been on whether it would tip over into double-digits or stay below 10 per cent. The additional 1 per cent in the inflation rate, taking it to 11 per cent, should in fact have been anticipated. As indicated by the sharp increase in edible oil prices, a commodity in which imports are quite significant, the rupee depreciation is also having an impact on the inflation rate. In the case of both petroleum products and edible oils, the recent fall in rupee value seems to have neutralized the impact of tariff reductions. Among other things, this highlights the limits on using such duty rate reductions as an enduring anti-inflation instrument.

The bottom line is that managing the political fall-out mitigates against the need to raise domestic fuel prices further. Virtually every other country in the neighbourhood is now reconciled to the inevitability. Malaysia recently raised prices by 41 per cent, while China announced a 16-18 per cent increase in its retail prices. Significantly, the Chinese announcement triggered a sharp fall in the international price of crude oil, suggesting that the development most likely to moderate prices is a reduction in consumption, which can only be achieved by consumers around the world paying full-cost prices for their fuels. This will undoubtedly cause pain because it will take the inflation rate to even higher levels, but the alternative, which involves an artificial suppression of inflation, could have a huge negative impact on an increasingly precarious fiscal situation. Other fiscal and monetary responses may play a supporting role but the only enduring solution lies in tackling the problem head-on.

It is certain now that the Reserve Bank will act to dampen demand and slow down the system, by either tightening liquidity or raising interest rates further. The latter is certainly called for, since deposit rates are now lower than the inflation rate. Banks continue to report strong demand for credit, and some say that credit is growing faster now than at the same time last year. This could reflect a shift in financing, from equity (stock market prices have fallen and share offerings are few) to debt. Most companies, on the back of five years of good growth, have strong balance sheets and therefore the credit risk is not large at the moment. Banks therefore are willing to lend, but they should be encouraged to do so at the right price. Higher interest rates are not popular in a system where bank-financed consumer demand has been responsible for rapid growth in many sectors (housing, consumer durables, automobiles). But they seem inevitable now. In the ordinary course, that should mean slower growth this year. The flattering advance tax figures suggest that most companies continue to do well, so Corporate India is not yet feeling the pinch of the slowdown that is now inevitable even if agriculture continues to do as well as it has done in the last three years.