Will monetary tightening help fight inflation?

DEBATE

While the finance minister is in favour of sacrificing some growth to curb inflation, the problem lies in inflation being more a supply-side than a demand-led problem.

Rajeev Malik,
Executive Director,
JPMorgan Chase Bank, Singapore

The Reserve Bank of India must tighten policy to anchor inflation expectations and to check the second-round impact of higher input prices

Fuelled by sharply higher international prices of oil and non-oil commodities including food, WPI inflation has shot up to a level that RBI Governor YV Reddy has justifiably labelled "unacceptable high". Politicians are in full damage-control mode: calls for interest rate cuts have disappeared, and the government has already responded with some fiscal measures.

But what about the RBI's response? Inflation is well above its comfort level of 5 per cent year-on-year, and the underlying causes of the surge are mainly foreign supply-side in nature. Essentially, India is getting whacked by an adverse terms of trade shock that is overlapping with softer external demand and, in all likelihood, a significant slowdown in capital inflows. Not doing anything is not an option for the RBI, in my opinion. Still, there is a limit to what monetary policy can achieve when there is little complementary progress by the government on the long overdue reforms, especially in agriculture.

The RBI must tighten policy to anchor inflation expectations and to check the second-round impact of higher input prices. It can hike policy rates, increase the cash reserve ratio (CRR), or appreciate the rupee, or a combination of the above. A policy rate hike is unlikely to be the first line of attack, as the high interest rate differential is already problematic. Also, investors' expectations of interest rate have undergone a major shift towards tightening, thereby lessening the immediate need for a rate hike.

Liquidity management will be the key focus of the RBI, and a 50bp CRR hike is likely, either in the run-up to or at the April 29 policy. The hike will probably be complemented with hawkish comments that won't rule out further action. Overall, a CRR hike offers a palatable balance between being seen as taking action without overdoing it. I doubt if the central bank will hike CRR and policy rates in one go.

Unlike other Asian economies, India runs a current account deficit that is worsening at a time when, unlike last year, there is high degree of uncertainty over the direction and magnitude of capital inflows. Also, rupee appreciation may not have a lasting impact on inflation (for example, last year's experience), while it will surely hit exporters, especially IT-related, at a time when they are already dealing with softening external demand.

Any whiff of policymakers favouring rupee appreciation will increase the speculative capital inflows wanting to capitalise on a stronger rupee, thereby possibly making the appreciation self-fulfilling. The last thing they need to do is to hint at a preference for appreciation but be ill-prepared for the ensuing appreciation and its consequences. Hopefully, the government has learnt something from the political and economic fallout from last year's outsized rupee appreciation.

Dharmakirti Joshi,
Director and Principal Economist,
CRISIL Ltd

Hiking interest rates works only when there is excess demand. In this case, the problem is the supply side. Hiking rates will only lower growth

The sudden spike in inflation from below 5 per cent to 7.4 per cent in the matter of six weeks has surprised all stake holders. This is amongst the sharpest surges in inflation in recent times. It needs no emphasis that inflation control is the key macroeconomic challenge at this juncture and requires an appropriate policy response. Already a variety of fiscal and trade related measures to tame it have been put in place. All eyes are now focused on how the RBI will respond to the abrupt surge in inflation. The RBI has so far stayed ahead of the curve by taking proactive measures for meeting growth and inflation objectives. Two years of tight monetary policy have moderated growth in the economy as targeted and cooled off some of the overheated segments in the economy. Despite easing demand, inflation has suddenly risen far beyond the RBI's comfort zone.

Normally, the central bank tries to control inflation by reducing demand. Therefore, the policy of raising interest rates is most effective when the inflation is demand-driven. The recent episode of inflation is triggered primarily not by demand but rather by supply-side factors. Oil, food and commodity prices have seen a sharp increase not only in India but virtually globally. Some of these factors such as food inflation have a structural component (diversion of food crops towards bio-fuel) as well as a transient one (supply disturbances in major food exporting nations). Neither of these can be addressed by a tight monetary policy. In the same vein, domestic monetary policy will not be effective in warding off pressures from global oil price surge.

A tight monetary policy over the last two years has had all the desired effects on the growth front. GDP growth moderated from over 9 per cent in 2006-07 to 8.7 per cent in 2007. Private consumption growth has come down in 2007-08. The growth in outstanding credit has slowed down to 24 per cent from 27 per cent in the preceding year. The IIP data reveals that interest sensitive segments such as consumer durables are slowing down. The global growth projections have also been scaled down for 2008-09. This will further ease the pressures from external demand. The GDP growth for 2008-09 is expected to slow to around 8 per cent.

Undoubtedly, the RBI has a difficult policy choice to make. We are in a macro scenario where the effects of past monetary tightening are still coming through and an unfavourable external scenario is likely to moderate growth further. The surge in current inflation is clearly not an outcome of loose monetary policy which needs to be rectified. So, raising interest rates will only bring the growth down faster with little impact on inflation. Not doing anything at this juncture would in itself be an important policy choice exercised by the RBI.

(The views are personal)