Deflating Some Myths On Inflation

Updated: Aug 25 2004, 05:30am hrs
Its May 2004. The wholesale price index (WPI) on a point-to-point basis is up 4.2%. The annual average rate of inflation has crossed 5%. But no one pays any heed. The glow of the India shining campaign has not quite faded, the country is in the thick of the elections, the economy has registered strong growth in the third quarter and no one, but no one wants to listen to saner voices pointing out that the prevailing low rates of interest are simply unsustainable. They are simply written off as Cassandras of doom.

Fast forward to August 2004. At 7.96%, the inflation rate is just a whisker short of 8%. Thats a close to 90% increase in the inflation rate in little over three months. Over the same period, global oil prices have risen by just about 15%. Clearly, for all the talk of high oil prices triggering an inflationary spiral, oil is not quite the villain its made out to be. So what is A poor monsoon A statistical illusion caused by a low rate of inflation in the corresponding period last year A fortnight after the report of inflation crossing 7.5% first spooked markets, the jury is still out.

Worse, our priorities seem all wrong. Instead of focusing on remedial measures, rising inflation numbers have led to a furious post-mortem on why prices have risen. And on whether or not it is a transient phenomenon. Not that this is irrelevant. We do need to know the answers to frame an appropriate policy response. But we also need to move beyond analysing the past to debating what needs to be done to tackle the situation. And this, in the case of inflation, boils down to just one thing: tighten money supply.

The reason is simple: inflation is ultimately a monetary phenomenon. One could argue about its causes; about whether it is cost-push (as with rising oil prices) or demand-pull (as when there is excess demand). But as The Econ-omist points out rising inflation has always (emphasis added) been caused by excessive monetary expansion. An increase in prices, regardless of underlying reasons, can occur only if the quantum of money in the system is out of kilter with the level of economic activity.

And this is precisely whats been happening during the past 10-12 months. Thanks to the huge liquidity overhang, interest rates are lower than warranted (real interest rates are negative across a broad spectrum of maturities), encouraging consumers to go on a debt-financed buying spree. The result, inevitably, has been a sharp increase in prices.

In many ways, this should have been anticipated. The writing has been on the wall for many months now. Indeed as far back as May this year, the Reserve Bank of Indias monetary policy statement drew pointed attention to the much higher increase in money supply in 2003-04 compared to the previous year. According to the RBI, the increase in reserve money or high-powered money in 2003-04 was almost double that of the previous year at Rs 67,368 crore. Most of this increase was on account of a sharp increase in one component of reserve money the RBIs foreign currency assets. Adjusted for revaluation, this component alone shot up by Rs 1,41,428 crore. This increase was over and above an increase of Rs 82,089 crore the previous year. The result, not surprisingly, was an unprecedented increase in reserve money.

No economy, least of all one that has not seen a significant expansion in capacity, can hope to absorb additional liquidity on this scale without it showing up somewhere either in asset prices or in commodity prices. To be fair to the RBI, it did try to neutralise some of the increase in money supply through open market operations (sale of securities to mop up excess liquidity). But the scale of these operations was nowhere near what was needed to mop up the excess.

Part of the reason, of course, was the NDA governments desire to keep fueling growth through artificially lower interest rates. Sure, the RBI could have put its foot down. But its lack of independence came in the way, perhaps. Whatever the reason, the net result was that money supply through most of last year was grossly in excess of that warranted by the level of economic activity. Not surprisingly, the annual average rate of inflation inched up to 5.4% in 2003-04 as against 3.4% the previous year thats an increase of almost 60%.

So does that mean the government is barking up the wrong tree by focusing on fiscal measures Possibly. The initial package of customs and excise duty cuts on petroleum products has been followed by duty cuts on non-alloy steel. And in a clear signal that he is not done as yet, the finance minister has promised more fiscal measures, if necessary. To the extent that these measures will bring down prices, at least of the goods on which taxes have been reduced, inflationary forces will no doubt be reined in. But only briefly. Excess liquidity has to show up somewhere.

The question then is, how should the authorities go about tackling inflation Remember, worldwide, inflation has been on the rise. Most central banks have realised this and some, like the Bank of England (BoE), the Reserve Bank of Australia and the US Fed, swung into action months ago.

The RBI has already left it too late, perhaps. But it can still take a leaf out of Paul Volckers book. The legendary chairman of the US Fed in the late 70s tightened monetary policy brutally in his Saturday night special. And while it hurt the economy in the short run, it also prepared the ground for the next three decades of growth. With low inflation.

If the RBI acts now, it can pack a less lethal punch. But time is running out. It needs to act, sooner rather than later, if we are not to see a return to the double-digit inflation of the 70s.