We live in intriguing times. High rates of growth keep company with high fiscal deficits and low inflation. Just as the government gets a handle on fiscal deficits, inflation begins to rise and growth falters. Either the dismal science has got its key macroeconomic relationships wrong, or growth and inflation are now globally coupled, over which sovereign control is fast falling.
Inflation across the world is led by a global surge in food, commodity and oil prices, and a steep fall in the international value of the dollar in which most trade is priced. Near recessionary conditions in developed countries, led by the US, which accounts for about a quarter of global demand, is sending growth south in all countries. Stockmarkets and capital flows across the globe increasingly resemble a Mexican wave in sport stadiums, with the US Fed as the chief choreographer.
In India, all talk of countercyclical fiscal policy, kickstarted by the Budget in the wake of recent quarterly GDP numbers, has been frozen by recent WPI figures, sending critics of the RBI?s tight monetary stance scurrying for cover. Even if questions remain on how monetary policy can target inflation.
According to monetarists, inflation is primarily?in Milton Friedman?s extreme formulation ?everywhere and always??a monetary phenomenon. Their logic goes something like this: if money supply were constant, and the price of a particular good, service or asset (say, sugar), were to rise, a fall in the demand for, and hence price of, other goods, services and assets would fall to compensate for the relative rise in demand for sugar. Ceteris paribus, the rate of inflation would remain constant, because aggregate monetary demand and supply tend to equate in a market economy.
However, if goods and services are tradable across borders, as they increasingly are, the slack in the domestic demand for tradable goods can always be supplemented by external demand, and so the overall inflation in tradable goods could well rise despite domestic money supply remaining unchanged. Conversely, excess money supply is likely to inflate the price of non-tradables, especially assets like stocks and real estate. As globalisation intensifies, prices of tradable goods are increasingly determined by international demand and supply. Most of the inflation in tradable goods over the past year, in India and abroad, has been in oil, commodities and food?marked by global demand-supply imbalances. Prices of most other tradable goods are remarkably stable on account of the efficiency effects of globalisation.
The Economist?s weekly indicators of April 3, 2008, indicate that consumer price inflation in the US increased from 2.4% a year ago to 4% at present, in Japan from -0.2% to 1%, in the eurozone from 1.9% to 3.5%, in Russia from 7.6% to 12.7%, in Brazil from 3% to 4.6%, and in China from 2.7% to 8.7%. In comparison, despite excessive money supply during the year induced by huge capital flows, the WPI in India has risen modestly from 6.56% a year ago to 7% in the week ending March 23, 2008. While RBI can take some credit, the key to lower inflation in India is the weak integration of Indian agriculture with world markets, which makes these goods effectively non-tradable.
With the weakening link between domestic money supply making it difficult to control inflation by targeting money supply alone, appreciation of the local currency could exercise downward pressure on domestic prices of tradable imports. If the bulging forex reserves were leveraged to offload dollars into the market to appreciate the rupee, money supply would also shrink, and exercise further downward pressure on inflation at the margin. This is one way out of the RBI?s ?monetary trilemma?, though the vexatious trade-off between inflation and employment would remain (via possible export compression and upward pressure on interest rates).
The writer is a civil servant. These are his personal views