Column: Pencil in another rate hike

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SummaryA sluggish economy does not mean RBI should become tolerant of high and rising inflation

One look at the accompanying heat-map and you understand why they often repeat that pictures-are-worth-a-thousand-words dictum. No matter how you measure inflation—using the yardsticks of CPI, WPI or GDP deflator—it has remained in the red zone, or above Reserve Bank of India’s (RBI) comfort level of 5% for many years now.

In India, assessing inflation can be confusing because the measures vary in terms of periodicity, coverage and even objective; at times, they even move in opposite directions.

Take, for instance, FY10, when wholesale price index or WPI-based inflation collapsed to 3.9% as domestic fuel and commodity prices crashed in line with the global economy. In that year, consumer price index or CPI-based inflation remained stuck at over 12%, which was the highest since FY01. Hence, the dip in WPI inflation in fiscal 2009-10 was a one-off and WPI kissed double digits in the following year.

But despite their limitations, all the three measures are unambiguous in their basic message: the price fire is far from being doused. When consumers encounter high inflation year after year, they begin to believe it is here to stay. In other words, inflationary expectations become entrenched.

So, predicting what a central banker would do when he looks at the heat-map is easy. Policy rates will be raised to tame prices. And if inflation is accompanied by high growth, the decision is a no-brainer. But that’s not the case in India at the moment. GDP growth has slipped sharply to 5% in the last fiscal and prospects for the current one are worse. CRISIL expects growth to slow further to 4%.

This creates a dilemma: should RBI focus on growth or high inflation? This is hotly debated every single time before the announcement of the monetary policy. We argue that a sluggish economy does not mean RBI should become tolerant of high and rising inflation. Therefore, the decision to raise interest rates on October 29—which implies that risks from high inflation outweigh risks from low growth—was appropriate.

True, demand is not behind current inflationary pressures measured through WPI—private consumption demand grew at a measly 1.6% in the first quarter of this year and investment demand continues to be extremely weak. Core inflation, which captures demand pressures, was muted at 2.1%, while inflation in non-core components (food, fuel, electricity) of WPI, which reflects supply shocks and structural rigidities, was at 10.3% in September.

Although core inflation rose marginally in September, this still does

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