The policy response to the latest inflation numbers in India has been predictable. RBI has increased the repo rate and the cash reserve ratio (CRR) like it has done quite a few times in the recent past. But will these be enough for taming inflation that is at a 13-year high?
The RBI?s moves draw attention to the ongoing debate on appropriate policy responses for controlling prices. The current bout of inflation is essentially of the ?cost push? variety. High energy and food prices have been instrumental in fuelling inflation all over the world. Is monetary policy the right response to curbing such inflation? Hikes in lending rates aim to sober prices by reducing demand. The worry is whether rate hikes will choke off the entire demand stimulus in the pipeline without making much impact on prices, which are going up due to entirely different reasons.
Major Asian economies have come up with a variety of policy responses for tackling the unusually high price levels. Institutional measures taken by some economies have been similar to those in India. Indonesia has raised policy interest rates, along with Philippines and Vietnam. Taiwan has also imparted a marginal upward push to interest rates. China?probably the most closely watched economy in the region?has been focusing on reducing liquidity without tinkering with rates.
Elsewhere in the region, central banks have been using currency appreciations, rather than interest rates, for battling inflation. Singapore is a leading example, followed by Malaysia. Currencies have also hardened in China and Taiwan. Harder currencies have helped these countries to absorb more cheap imports, which, in turn, have helped in keeping costs of production low.
Variations in exchange rate movements have been quite marked across the region. India has slipped into a phase of sharp depreciation from early this year, after several months of appreciation. The shift has been precipitated by large chunks of outflows from the capital market. Indeed, the rupee could have depreciated further had interest rates not gone up. Similar sharp falls in currencies have been experienced by Indonesia and Philippines. All these economies would be expecting capital flows to reverse direction so that domestic interest rates can be brought down once the local currency becomes stronger. Globally, however, foreign exchange markets have got enmeshed in a peculiar mix of contrasting forces. With US interest rates continuing to remain low, fund managers are divided over the short-term outlooks and quality of prospects between North American and Asian markets. Fund flow to Asian markets might remain limited to a few till investors acquire firmer perceptions.
In addition to monetary and exchange rate measures, most of the Asian economies have been forced to rationalise fuel subsidies. China has been the latest to increase fuel prices. The moves have led to political backlashes and public discontent. Realignment of domestic prices with global crude prices has been much easier in economies like Singapore, Hong Kong and Korea, which do not have a tradition of fuel subsidies. But it hasn?t been so in India, Indonesia and Malaysia. For these economies, supply-side responses in the form of revision of domestic fuel prices have aggravated the already-high inflation, leaving precious little room for further policy manoeuvre.
So, what should be the most effective policy response? The Asian experience seems to indicate that there is no unambiguous choice. Countries are reacting to inflation in line with their specific circumstances and priorities. Monetary policy may not be the most virtuous of measures to adopt, given that the genesis of the problem is essentially on the supply side. Many would argue in favour of the exchange rate being used as a more direct policy instrument. India, however, appears to have lost the policy space to leverage exchange rates given the sharp depreciation. That leaves only specific supply-side responses like cutting subsidies by revising fuel prices. Almost all Asian economies have done so. However, the problem with such a measure is that it might aggravate inflation and necessitate interest rate hikes. This is exactly what?s happening in India.
The trade-off between policies and their outcomes needs to be assessed carefully in economies like India where inflation has reached disturbing levels. It is evident that policy responses aiming to achieve short-term objectives are unlikely to yield results. Oil prices are not showing signs of softening. More revisions in domestic fuel prices will be required sooner or later. But interest rate hikes should not follow automatically. A careful combination of interest and exchange rates aiming to increase capital flows can be helpful. At the same time, there is little point in fighting shy of cheaper imports. Indian consumers won?t mind eating cheaper Thai rice as long as it tastes as good as home-grown varieties!
?The author is a visiting research fellow at the Institute of South Asian Studies (ISAS) at the National University of Singapore (NUS). These are his personal views