This was coming. After inflation slid into the double digit zone on Friday in what could be an election year, it was a question of when rather than if Reserve Bank of India would hike rates and squeeze credit. The question that the bank leaves unanswered is whether we could have had a lower rise in rates?had the monetary transmission mechanism been allowed to develop in the economy, something most financial sector reports have argued for. A critical input for a seamless transmission mechanism is well-developed bond, currency and derivative markets, as our columnist points out. But these have not developed largely because of a clear reluctance from policy mandarins. So the economy pays a higher cost through a higher interest rate. This is no academic quibbling, as each basis point rise means a higher cost of doing business for India Inc. At any time the lack of efficiency this generates is a cost in terms of foregone growth. The finance minister has argued that the way to handle the inflation spurt this time around is the monetary mechanism. But RBI is rendered less effective by its own rigidity?there are very few mechanisms to make remedies work. So the current crop of measures is a good way to treat inflation?a future one, that is.
The lag between any steps announced and their impact is usually a year. A map of the relationship between the growth of M3, year-on-year, and that of manufacturing inflation in the last ten years shows a strong correlation. This is not just a happenstance but a clear indication that the rise and fall of money supply and, therefore, of bank credit drives manufacturing inflation. What about the link between the growth of M3 and that of inflation in primary commodities? That, too, is present, but in a weaker link. There is a break in this relationship during 2007-08, but there is strong evidence for this at an earlier time, especially between 2005 and early 2007. So, RBI is theoretically on the right track in its move to hike repo rates and the cash reserve ratios by 50 basis points each. There is little doubt that curbing money supply does dampen an inflation build up. However, it is the effectiveness of this policy in practice now, and the costs it will extract in terms of its impact on the real economy, that is the issue.