Inclusive growth, financial inclusion fanning inflation, say Anant & Basu

Economic policy formulation is based on ?ceteris paribus? assumption ? a Latin term meaning ?all other things being equal or held constant?. In reality this is never the case, and monetary policy formulation is no exception.

The Reserve Bank of India (RBI) will have to grapple with several imponderables when it formulates its first ever mid-quarter policy, to be detailed on Thursday, to deal with inflation.

The government?s chief statistician TCA Anant and chief economic advisor Kaushik Basu have flagged two factors that are fanning inflation ? Prime Minister Manmohan Singh government?s thrust on inclusive growth and financial inclusion.

Both goals are important for sustained high economic growth but the programmes? off-shoot appears to be high inflation rate, for which there seems to be no short-term solution.

Food inflation is 11.5% (in the week to August 28); wholesale price inflation for all commodities was a wee bit below 10% in July. Inflation beyond 6% is perceived to be outside the comfort zone.

RBI is in an unenviable situation ? its monetary action to deal with demand-driven inflation seems to have no control over these hidden pressures.

New inflation growth dynamics

?Inflation in recent years is the flipside of inclusive growth,? Anant said. ?In the past, rise in inflation used to be in line with (gross domestic product) growth. But in the last three or four years, inflation trend is different,? he said. ?The policy of inclusive growth has pushed up demand for wage goods substantially in rural areas. Supply of these goods has not matched demand,? he said.

The big social sector programmes have raised incomes of the poor and given them some spending power even in the worst of times.This combination of inflation and growth does not mean there is overheating of the economy, which could call for slowdown in GDP growth. In fact, India needs higher growth for faster poverty eradication.

?I don?t see any evidence of overheating?India needs to have high growth,? said Pronab Sen, principal advisor to the Planning Commission.

The imponderables ? financial inclusion and inclusive growth ? that have entered into the system and difficult global economic scenario have resulted in a peculiar situation that calls for frequent monitoring and policy reviews.

?RBI?s decision to have mini-quarterly policy review is a good thing especially when you have an unusual situation,? Sen said.

?In an unusual situation, stability of policy rates is less important than managing the system?It is a sensible decision. It provides options,? he said about the central bank?s decision to have eight policy reviews each fiscal year instead of four.

The new system begins with the first ever mid-quarter policy review on Thursday. The country is at the cusp of a major economic surge. Per capita income is growing at 7% annually, which means it will double in 10 years and rise eight-fold in 30 years to join the list of industrialised nations, observed Basu.

Social sector and money supply

National employment guarantee programme, substantial increase in minimum support price for various farm products in recent years and emphasis on rural infrastructure development has led to prosperity in rural areas.

Basu said 41% of rural savings, which were so far in the form of cash stashed under the pillow, are beginning to enter the banking system with new emphasis on rural banking.

?This money, which was out of circulation so far, has started influencing prices as people increasingly inject the money into the banking system,? he said.

The amount equals 2% of GDP, or Rs 1,40,000 crore. This compares to budgeted fiscal deficit of 5.5% of GDP, or Rs 3,80,000 crore, for 2010-11 (April-March).

The impact of this money entering the system is equivalent to reducing banks? cash reserve ratio by 250 basis points.

Early this year, RBI increased CRR by 100 bps as it anticipated inflationary pressures.

Between October 2008 and April 2009, it cut CRR by 400 bps in several tranches from 9-5% to mitigate the ill-effects of global crisis on India?s growth.

This additional money entering the banking system arising from social sector programmes is one of the reasons banks? complaint of tight liquidity position was muted when Rs 110 crore billion flowed out of the system for third-generation mobile spectrum payment in June.

Unpredictable outcomes

The central bank is in a difficult situation. Policy actions are overtaken by unforeseeable events. It has to walk the tightrope between balancing growth and inflation.

Fiscal and monetary policies will have to be calibrated in a manner that does not impede growth momentum while taming inflation. There will be some amount of inflation when growth is high, Anant said.

Supporting growth fighting inflation

With growth a priority for the government and RBI, ?nothing would be done? in Thursday policy that has the potential to hurt growth, said a top government official on the condition of anonymity.

The central bank is expected to reiterate inflation control is its key task as it did in its last policy review on Jul 27. RBI can, at one go, suck out entire excess liquidity.

It can also take harsh steps by hiking policy rates sharply. But RBI won?t do that because such a move can retard growth, said the official. No wonder then RBI governor D Subbarao has been advocating ?baby steps? in moving away from loose monetary stance of last two years.

Some policymakers were impatient and demanded bolder monetary action against inflation.

For example, in June when food inflation was 14.6%, Prime Minister?s Economic Advisory Council chairman C Rangarajan publicly demanded stronger steps from the central bank.

Finance minister Pranab Mukherjee, too, was vociferous in demanding action ahead of the Jul 27 policy review.

However, after fresh analysis threw up new reasons for inflation, policymakers and economists are slowly coming around to Subbarao?s idea that small steps are more prudent and will ensure growth with stability.

They will also help curb inflationary expectations. M Govinda Rao, a member of PM?s economic advisory council, said expectations from RBI?s Thursday policy are in line with this new thinking. He said the central bank may go for small hikes in repo and reverse repo rates but leave cash reserve ratio–and liquidity–untouched.

Summing up the paradoxical Indian economic situation, Delhi School of Economics? professor B.L. Pandit said monetary policy action is no solution to surging prices now. ?Current inflation is due to neglect of agriculture,? he said. ?There can only be a medium- to long-term solution to inflation?-that is through increased investment in agriculture and rural development,? he said.