On the morning of July 31, when Reserve Bank of India Governor D. Subbarao presented the first-quarter monetary policy review, the message was clear: RBI could not fight inflation alone. It also revised the inflation forecast from 6.5 to seven per cent in March 2013.
That evening, it was announced that P. Chidambaram would take over as Finance Minister. About a week into his new job, he declared that fiscal policy would work in tandem with monetary policy. He said a committee would draw up a fiscal consolidation plan. But the government's ability to take hard decisions may have been compromised by a long period of inaction.
RBI has continued to tighten monetary policy, but inflation is intractable
. Headline wholesale price index inflation rose from 7.5 per cent in April to 7.6 per cent in May, and moderated to 7.3 per cent in June. Primary food inflation was in double digits
in the first quarter of 2012/13. Interest rates are high. Now, drought adds urgency to the situation. It is likely that 2012/13 will be worse than 2009, when India suffered drought and a downturn. "The 2012 slowdown is triggered by the domestic economy," says CRISIL Chief Economist D.K. Joshi. "We don't have the firepower that we had in 2009."
Effective fiscal consolidation would mean - among other things - cutting back on subsidies. In April and May 2012, food subsidies were lower but fertiliser subsidies were more than twice the previous year's level. The RBI says that if the government is serious about curbing subsidy expenditure, it should start with fuel and fertiliser. But the current economy makes it harder for the government to act aggressively. It will have to spend more on schemes such as NREGA and find ways to boost rural demand, a key driver of the economy.
In 2008/09, the economy grew 6.7 per cent and there was room to intervene. Now, with the fiscal deficit at 5.8 per cent, stimulus measures could be disastrous. Fitch recently downgraded India's credit outlook to negative, and Standard and Poor's warned of a downgrade to the junk category. Taking on more debt could be fatal for India's global standing.
"We have not pushed through expenditure reforms, so we will feel the inflation stress a lot more," says Anubhuti Sahay, Senior Economist at Standard Chartered Bank India.
Even if RBI and the government do work together effectively to reduce inflation, the pain won't go away for another six months.