The Tight Rope Act

Walking the Tight Rope

With inflation hitting new highs, the regulators have a daunting task of keeping the growth engines running and controlling inflationary conditions.

With fears of an economic slowdown looming large and with US already in recession, the last tranche of bad news needed was a spiraling interest rate. The rising interest rate phenomenon has been witnessed across most emerging market economies. And the men who has been left asking for a fine balancing act is the RBI governor, Mr. Y.V Reddy and the Finance minister, Mr. P. Chindambaram. The sub 7% interest rate number is way above the RBIs comfort zone. The FM has already come out all guns blazing saying that the govt. will introduce a slew of monetary and fiscal measures to control inflation. So where does this leave us and what are the various tricks the govt. has in its sleeve ?

The government has a very tough task on its hand. If the central bank were to raise interest rates further, it would lead to a slowdown on the economic growth front with the credit growth already dwindling. The sale for various credit sensitive items has already taken a beating over the past year on the back of high interest rate regime. And each time we increase the interest rates, the interest rate differential between India and other developed economies increases further, encouraging arbitragers and other investors to pour in dollars leading to a weaker dollar. The export sector has already been pressed hard to make ends meet and a further strengthening in rupee would be the last thing they could have asked for. A developing economy like India which has been running a rather huge current account deficit cannot afford to hurt exports of goods and services which would have serious ramifications for the sustainability of the growth in the future. The interesting thing to watch out for would be the instruments which the central bank uses, in the hope of deflating the inflation bloat.

Another move the govt hopes to make use of is reduction in import duties. A reduction in import duties coupled with a stronger rupee might make imports competitive but I doubt if it could result in any meaningful reduction in prices because of high price levels being witnessed in the global commodity markets. The global commodity prices have hit the roof on back of low food grain surplus, if any and on concerns of continued availability of non renewable energy resources in the distant future. The real solution to taming inflation in the long run lies in improving our agricultural productivity and removing infrastructure bottlenecks for which lies no easy make fix solutions. But for now the persons at the helm of the affairs have been left with walking the Tight Rope to reign in inflation.

Split Wide Open

The Community of Economists and bankers are in splitsville with opinions differing significantly on the effectiveness of the policy actions mentioned above, in controlling inflation. One sect of economists houses the view that the present inflationary conditions which are being witnessed is because of supply constraints and hence increase in interest rates cannot address such an issue. Infact it would have a negative impact by effecting demand adversely, and when the inflationary pressures have really bottomed out in the form of improved supply, the demand for them would have taken a beating. All this would derail the economic growth engine. At the same time another group of Economists believe that the central bank should act swiftly, and justify the first mentioned approach to tame inflation.

It remains to be seen as to which path the central bank threads to control inflation. And hence walking the fine line of inflation and growth is becoming a daunting challenge.