Inflation: sources and policy options

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Friday , May 09, 2008 at 2220 hrs US rose from 2.8% in March 2007 to 4% in March 2008. The corresponding increase in the euro area was from 1.9% to 3.9% and in Japan from -.2% to 1%. Bric countries have fared much worse, with CPI inflation rising from 3% to 4.7% in Brazil, from 7.4% to 13.3% in Russia and from 3.3% to 8.8% in China. In sharp contrast, CPI inflation for industrial workers in India fell from 7.6% to 5.5%. The rise in domestic inflation is relatively modest by global benchmarks on account of rupee appreciation, monetary tightening and because India is more or less self-sufficient in food, Indian agricultural markets are not well integrated either nationally or globally, and POL prices are administered.

Money supply has been growing at around 21% in the last three financial years, about 4% above what is necessary to ensure price stability. Most of this increase is on account of FDI and FII inflows, only part of which could be impounded through sterilisation and increase in reserve money. Of the $299 billion of forex assets with RBI as on March 28, over a third was added during the last financial year alone.

Nothing can be done about the base effect and global inflation, and there is little space to use fiscal policy without serious fallout on inflation over the medium term. That leaves monetary and exchange rate policies, apart from boosting supply over the medium term. While monetary tightening and exchange rate appreciation could affect growth in the short run, there is no long-term trade off between growth and price stability, since high inflation dampens growth.