Business Today

This inflation has nothing to do with monetary policy

By tightening monetary policy, we won't solve inflation. But we will succeed in shackling growth.

Bibek Debroy        Print Edition: February 7, 2010

Seven point nine per cent GDP growth in Q2 of 2009-10 is deceptive. India is certainly not on 9 per cent growth trajectories, perhaps not even on 7.5 per cent, though we may approach that kind of real GDP growth number in 2009-10. Indian growth has been driven by investment, consumption and exports. None of these three components yet shows signs that so-called green shoots are becoming trees.

If we did 7.9 per cent in Q2 and approach 7.5 per cent in 2009-10, that will be because of government expenditure. And this is unproductive government consumption expenditure, not public expenditure leading to assetcreation. This is also unsustainable because resources have opportunity costs and through this government expenditure, we have cross-subsidised the relatively-rich at the expense of the relatively-poor. Until private investment, private consumption and exports recover, there is every reason to look for clouds in that silver lining of 7.9 per cent.

Interest rates in India are high, and high growth since 2003-04 has been driven by lower real interest rates. Prime lending rates (PLRs) are misleading as little lending occurs at PLR. Interest rates are high because of cross-subsidisation of priority sector lending, floors on deposit rates effectively set by administered rates on small savings, inefficiencies (measured by spreads) in banking system and high government borrowing. A few companies accessed global capital, but this wasn't broad-based. We have done nothing to reform structural rigidities leading to high interest rate regimes.

With this upward bias still existing and growth recovery still fragile, it will be a mistake to take measures on liquidity or policy rate increases. We slowed down growth even before global financial crisis surfaced in September 2008. We slowed it down by increasing interest rates, particularly in 2007, and brought growth down from 9 per cent to 7.5 per cent. There is a danger we might do that again soon.

The inflation bogey is a red herring. Inflation is high, but only food price inflation. This has nothing to do with monetary policy. Nor does it have much to do with drought, some specific items being an exception. Food prices have increased continuously. Because agro-cum-rural reforms haven't been introduced, the supply curve is inelastic. And rural demand has increased because of farmers' debt relief, MGNREGS, pure income effects and changes in consumption patterns. Organised purchases by large-scale retailers may also have a role in this.

Rather oddly, intermediation, measured by gaps between what farmers get and what consumers pay, also seems to have increased, especially for fruits and vegetables. This has nothing to do with drought because it preceded drought and some items are perishables. With reforms, dis-intermediation occurs and distribution chains collapse.

While there haven't been reforms, what is odd is that distribution chains seem to have become longer rather than collapsing. Despite links between political classes and agri marketing, this counter-intuitive phenomenon needs explanation. The point is that we should now do something about agriculture reforms instead of only talking about them. To return to the original issue, by tightening monetary policy, we won't solve inflation. But we will succeed in shackling growth.

The writer is an Economist and Professor, Centre for Policy Research, New Delhi

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