As inflation continues its upward spiral, fuelled by high food and crude prices, RBI is set to raise interest rates to curb its rise. How will a rise in rates affect the economy?s growth rate?
We examine the issue, as always, in a simple Q&A format
What is inflation? How does it emerge?
Inflation is a situation where there is too much money chasing too few goods and services. The rise in demand pushes up the cost of the goods and services, effectively making each rupee worth less. This is reflected in the erosion of the purchasing power of money. Any sort of inflation results in the rising of prices. A low inflation number means that although prices are rising, they are rising at a slow rate.
Inflation can be created by a rise in demand, which makes it demand-pull inflation. It can also be created by a rise in the cost of inputs, which leads to a rise in prices of the final product. This is known as cost-push inflation. The third is structural inflation, where a persistent shortage in the supply of a good or service raises its price. The current phase of rising vegetable prices is one of structural inflation. In its origin, cost-push inflation too is basically a demand-pull phenomenon.
What is the role of a larger money supply in inflation?
Economists agree that, in the long run, inflation is a product of increases in the money supply. In the short run, however, it may be attributed to demand and supply issues. A higher supply of money comes into the hands of people via three sources:
i) When the government or other employers pay higher wages.
ii) When the rates of interest on borrowings like credit cards, personal loans and even collateral-based loans like housing or car, are kept low.
iii) In countries like India, additional money is also pumped into the economy through government expenditure on subsidies, social security programmes, like the NREGA and so on.
Would a higher supply of money impact the rate of interest?
This is where the story becomes complicated. Central banks generally believe that a higher supply of money leads to inflation and so a practical way to cut back price rise is to raise the interest rates. In other words, with a rise in the cost of holding money, people would borrow less from banks to finance their business. This applies even to personal loans, including credit cards.
But the situation gets murky when possibility (iii) also takes place in the economy, i.e., the government also pumps in money. Since the government does not factor in the cost of money, the central banks are caught in a bind. Some economists say the money supply in the economy should not be determined exogenously by the central bank as it is always behind the learning curve.
Instead, money supply should grow at a steady rate keeping pace with the rate of growth of the real GDP.
According to these economists, central bank interventions create wrong signals for the economy. There will be phases, for instance, when the low rate of interest would give a signal that the cost of investment in an economy is low. This spurs people to make more investments in everything from housing to complex industrial projects.
The investments, in turn, create more wages for the employees, which further increase the supply of money in the economy. But central banks do often follow a policy of intervention, especially when they wish to spur growth. In India, RBI has done this on several occasions, often selectively, by encouraging low rates for sectors believed to be socially desirable.
But when the inflation rate rises, central banks step in to raise the interest rates. They do so by making credit costlier for banks. The step acts as a mop-up of excess money supply in the economy. Colloquially it is known as taking away the punch bowl when the lending party is in high gear, returning sobriety to the economic actors.
What is the current condition of the Indian economy?
Analysts agree that inflation is at an intolerably high rate in the economy and so needs to be cut back drastically.
At the same time, investment is also running high, with incremental credit from the banks running at 23%, higher than the RBI estimate of 20% for the year. The consequent expectation is that the economy will end this fiscal, with a growth rate of about 8.5%. So analysts expect RBI to remove the punch bowl by raising interest rates.
Why may this not work?
This line of reasoning assumes there are no shortages in the economy. In other words, the only basis on which people will decide whether to invest more and, therefore, pay higher wages is the cost of capital?the rate of interest.
But the current episode of inflation in India has occurred mostly in food prices, that too, in those commodities whose supply is restricted. An FE analysis of last week has shown that while prices of agricultural goods have risen by at least 50% in the last decade, the prices of manufactured goods have risen less than 10% and in some cases stagnated. This was, in most cases, directly related to the levels of production?production stagnated in agriculture and prices rose, production grew in manufacturing and prices fell, or rose by a lesser amount. This means along with a rise in the purchasing power of people over the last few years, the supply of superior goods from the farms, like vegetables, has not risen at all. This is the reason for the price rise in those commodities.
Going ahead, the government through its various social security programmes will continue to pay wages to more people than ever before. The demand from these people will push up market prices even more. The implication is that even though RBI would have raised the cost of money, this rise will impact only the sectors that depend on borrowed funds?industry.
Thus, a rise in the rate of interest will not cut the provision by the government to these people through the wage support programmes like NREGA. It will also not cut the flow of credit to the business of food, where banks give loans at lower rates of interest. Instead, it will only cut the investment plans of manufacturers and since it is these investments that are powering the growth rate of the economy, the impact will be felt on the growth rate of GDP.
What will be the impact on inflation and interest rates?
In the process, the economy could find itself in the worst possible combination of high and persisting inflation and a lower rate of investment. The key difference as RBI announces its quarterly review of the monetary policy this morning is, therefore, on how one reads the signals from the manufacturing and the services sector. RBI broadly believes that growth is on track, despite the recent blips, and in the trade-off between growth and inflation, it is the latter that needs to be clipped. This reading is not shared by the government in its action, even though the finance minister may endorse the stand for the record.