The Indian economy is slowing at a sharper rate than expected, but inflation refuses to ease. Overall WPI inflation persisted at close to double digits with core (non-food manufacturing) inflation at 7.4% during April-September 2011. I believe that RBI should retain its tight monetary policy stance and raise the repo rate by 25 basis points on October 25. The recent evidence shows that the supply shocks have not been temporary but stubbornly persistent due to support from healthy demand. Consequently, inflation has remained high and expectations continue to be elevated.

One-off supply shocks do not require monetary policy action. But when supply shocks start displaying signs of permanence, as appears to be the case in India, a tight monetary policy is essential to restrict their transmission to other sectors. The inflation episode of the 1970s in the US is a grim reminder of the manner in which inflationary expectations can become entrenched in the economy if a tight monetary stance is not employed to rein in the spread of persistent supply shocks. Paul Volcker had to use a sledgehammer of high interest rates and credit squeezes, and the US economy had to be brought to a grinding halt to tame inflation and anchor inflationary expectations. In India, the current episode of inflation can be ranked amongst its most challenging spells in

recent memory. Average annual inflation rose by over 1 percentage point during the last six years to 6.2% from 5.2% in the previous decade. The unrelenting nature of inflationary pressure can be gauged from the fact that in the 66 months

beginning April 2006, WPI inflation has remained above RBI?s comfort level of 5% for 48 months, above 6% for 44 months, above 7% for 34 months and 8% for 28 months. In the last 20 months, inflation has remained above 9%. When agents see a continual rise in inflation and believe that it will be long lasting, inflationary expectations become entrenched.

The inflation data shows that over the last few years, the supply shocks have become deep rooted, and have now spread to core inflation.

Food inflation increased to an average of 10.3% in the last six years (2005-06 to 2010-11) from 5.3% in the preceding decade because of stagnant productivity in agriculture and rising demand. The growth in demand has been supported by the rise in wages, which, in turn, has been partly aided by the hike in the floor on wages by MGNREGA. Upward pressure on wages is likely to continue in view of skill shortages at both the high and low end of the job market. Wage and food price shocks, therefore, may persist. The supply shock from high commodity and crude prices had eased during the global downturn in 2009, but this proved to be temporary as commodity prices bounced back in 2010 and dragged non-food inflation up again. We might see a sharp dip in commodity prices if the advanced countries slide into a second recession. In the absence of a double dip?which is now the base case for most macro assessments?there is not much downside to commodity prices.

Core inflation, regarded as the indicator of demand-side pressures on inflation, remained high, at 7.6%, in September. The month-on-month momentum of core inflation had weakened in the last few months, but picked up again in September 2011. If demand-side pressures on inflation have to be deemed under control, core inflation needs to come down to around 4-5% and remain in that range. For lowering inflation expectations, overall inflation must not only reduce, but must also stay at low levels. This has not happened so far.

Finally, monetary policy needs the support of fiscal discipline to curtail inflation, as pointed out by Sargent and Wallace way back in 1981 in their seminal paper, Some Unpleasant Monetarist

Arithmetic. Otherwise, inflation control will continue to challenge policymakers.

The author is chief economist, CRISIL. Views are personal

Rajiv Kumar

It is perhaps a foregone conclusion that RBI will raise the repo rate once again when it announces its credit policy later this month. This has been widely indicated by senior RBI officials, including the governor and deputy governors. According to them, inflationary pressures and expectations in the economy are much worse than is apparent from the statistics available. It should be incumbent upon RBI to share the information they have on inflationary expectations on the basis of which they will hike up interest rates for the 13th time in about 19 months. I suggest that RBI postpones its announcement by a few days until after Diwali so as not to start the new commercial year on a mournful note!

FICCI?s Business Confidence Survey, on the other hand, shows that inflationary expectations are weakening. According to this, inflation should already be on a downward trend in the next quarter, a conclusion reiterated by the finance secretary, as quoted in newspapers on October 18. We have always been told that RBI pursues the triple objective of sustaining growth, generating employment and controlling inflation. In its recent actions, however, RBI has tended to behave with a single-mindedness that will please the staunchest supporter of inflation targeting. But as we have pointed out above, and has been argued by others, even as an ?inflation targeter? RBI should now be taking a pause to move ahead of the curve rather than persist with further hiking the rates. Any further tightening, coming at a time when the rupee is depreciating and imposing higher costs on imported intermediates, will surely put the economy in an even sharper downward spiral. FICCI?s Business Conference Survey also shows that a significantly larger number of respondents expect the economy to slow down further in the coming six months. It will be a pity if conscious policy action intensifies the slowdown further.

Inflation-targeters in general, and defendants of RBI?s continued policy tightening will argue that further action is needed until the economy has slowed down to below its rate of growth of potential output. This has been estimated by various agencies as between 8-8.5%. Any rate of economic growth above this is seen as inflationary, which requires to be cooled down. Even on these grounds, a pause is now called for because the GDP growth rate is already below 8% and is likely to remain so in the coming quarters. Further tightening will ensure that the downswing is much longer and deeper than required. Second, in a poor country like ours, rapid economic and employment growth is essential for maintaining social and political stability. Hence the preference for pursuing a triple objective rather than only targeting inflation.

In this context, it is important to try and raise the rate of growth of potential output by removing the constraints on the supply side. In the given orthodoxy, tackling supply side constraints is not a part of RBI?s mandate. In our situation, however, we must jettison orthodoxy and adopt any modality that help us to achieve our objective of rapid employment and economic growth. This will perhaps require that RBI, which can take a more technical and less politicised view of economic policy, takes the lead in arguing the case for structural reforms and fiscal discipline and building a consensus within the political class for such reforms. This is the only way forward for moving the structural impediments on investment and growth. In the absence of such reforms, RBI may be forced to scarify growth completely in order to squeeze out inflationary expectations. This is a socially explosive prospect in these days of rising expectations and sharp public response accentuated by a hyperactive media.

The author is secretary-general, FICCI.

(As told to Sunil Jain)