Never before in Indian economy has high growth existed with rising interest rates and inflation. Yet it has happened now and the RBI and finance ministry face a ?trilemma? that has no precedent in almost any economy of the world.
How they solve it will impact industry which needs the growth momentum to continue, the large middle class which is affected both by inflation and interest rates and the farmers whose fortunes are tied to inflation primarily.
An analysis of the movement of inflation, GDP growth and interest rates in the Indian economy for the past twenty years shows why the current period is unique. From 1993 to 1997, GDP and rates of interest rose, but inflation eased up. The same thing happened between 2003 and 2007. But in 2009-10 and now all the three statistics are moving upwards. No wonder presenting the Annual Policy statement for 2010-11, RBI governor D Subbarao said, ?India?s growth inflation dynamics are in contrast to the overall global scenario?.
The downside risks for the domestic economy have shifted from growth slowdown to inflation. So the policy stance should recognise and respond to this transition. And this was the rationale for the hardening of the policy stance. The first major threat of inflation after the reforms was in the mid nineties when the WPI numbers swerved up sharply after declining steadily in the early years of the decade. WPI inflation sharply shot up from a low of 8.3% in 1993-94 to 12.6% in the very next year mainly on account of a pick up in both food and manufactured good prices which both hit double digit levels.
The consequent change in monetary stance forced a sudden hike in minimum interest rates from 14% in 1993-94 to 16.5% in 1995-96. The lagged impact of this sharp hike in interest rates pushed down GDP growth eventually from a decadal high of 8% in 1996-97 to almost half to 4.3% in the very next year. Though inflation rates was brought down to one fourth the peak levels with the WPI reaching a low of 3.3% by the end of the decade it took almost seven years to push up GDP growth back to the 8% mark in 2003-04.
However, the continued softening of the bank lending rates till it reached a low of 10.5% in the middle of the current decade helped boost growth to above 9% for three consecutive years in the mid nineties. But a change in monetary stance and the hike in bank lending rate in 2006-07 and the global crisis once again led to a sharp deceleration in the economy with the growth rates slumping to a new low of 6.7% in 2008-09.
However, the change in monetary stance was short lived as inflation picked up sharply in the second half of 2009-10 with the monthly rates almost touching double digit levels by the end of the year as the increase in food prices slowly spilled out into the manufacturing sector and with no sings of any abatement. And now with the central bank giving a baseline growth projection of 8% in 2010-11 we will have a unique scenario of all three indicators namely GDP growth, interest rates and WPI inflation moving up in tandem at the same time. The big question now in this scenario is will this change in monetary stance and yet stronger measures cause a roll back of both growth and inflation, as it did in the mid nineties, or can it be nuanced enough to boost growth and control inflation at the same time. We will have to wait and watch as the scenario unfolds.