The continuation of high inflation in the country for close to two years, juxtaposed with recent industrial slowdown, has been a matter of grave concern in policy circles. The seriousness of the situation is evident from the fact that the Prime Minister called for a high level meeting of eminent experts in the government to discuss the issue.
Recent data reveals that despite a series of hawkish policy initiatives, inflation in September 2011 was at a high of 9.27 per cent, much above the comfort zone of the RBI. This was against inflation of 9.22 per cent and 9.78 per cent, in July and August 2011, respectively. Adding to the concern over high rates of inflation is the deceleration in industrial growth over two successive months of July (3.8 per cent) and August 2011 (4.1 per cent).
This has created a Catch-22 situation for RBI's forthcoming monetary policy review.
There is widespread belief in the market that RBI will raise its main policy instrument, i.e., repo rate under liquidity adjustment facility, by 25 basis points. The recent pronouncements by the RBI Governor Dr. D. Subbarao and Deputy Governor Dr. Subir Gokarn, appear to point in that direction.
SUPPLY CONSTRAINTS
However, large sections of industry and several analysts are apprehensive that the continuous hike in interest rates will stifle industrial growth without producing any favourable results on the inflation front.
The counter-argument as put forth by Dr. Subbarao was that in absence of such commitment against inflation, it would have been much higher than the current levels. The counter-argument cannot be entirely ignored.
Some analysts elaborated on the role of supply factors versus demand factors and discounted the efficacy of recent rate hikes by the RBI to counter the current inflationary run.
As for supply deficiencies causing the recent inflation (as argued by Prof. Pulapre Balakrishnan in his column in this daily), the appropriate long-term policy would have to be coordinated policy action to augment and sustain agricultural production, in keeping with the expanding demand for food products.
The near-term policy should be appropriate import management policy in sync with domestic agricultural production.
DEMAND PRESSURES
Without diluting the importance of supply management policies, there is still some justification for monetary tightening in the forthcoming policy. First, irrespective of supply versus demand related arguments, at a micro-level, inflation in manufacturing (with a weight of close to two-third in WPI) is an outcome of the price-setting procedures adopted by producers.
Under this, prices are set taking into account the expected increase in the cost of labour, raw material and interest payments. Inflation expectations for the future, therefore, feeds into the pricing decisions of the producers.
In this backdrop, the central bank's commitment to price stability is critical for anchoring inflationary expectations, and a repo rate hike by 25 bps will be the signature of RBI's commitment to low and stable inflation.
Second, the continuous rise in housing prices and strong demand for automobiles even in the semi-urban and rural areas do not rule out the role of purchasing power in the current spell of inflation. In September 2011, the year-on-year growth of bank credit was 21.4 per cent, compared with a growth rate of 20.2 per cent in September 2010.
In smaller cities like Puducherry, it is reported that the waiting period for delivery of two-wheelers after booking is two to six months. With the growth of the motor vehicle segment at a rate of 15.5 per cent during April-August 2011 over the corresponding period of the previous year, the role of rising demand in inflation cannot be ruled out.
(The author is Reader, Department of Economics, Pondicherry University.)