LONDON: India is behind the curve on inflation. It's not just that weekly food inflation has hit 18 per cent; the current account deficit is also uncomfortably high. The authorities need to get a grip, even if that means sacrificing 9 per cent GDP growth in the coming year. Structural reforms, not loose policy, are the only sure way to sustain rapid growth.
An immediate cause of the inflation spike was a sharp rise in the price of onions, an important element of the Indian diet. As the next crop comes through in a couple of months, the headline rate will drop dramatically. But there are increasing signs that inflation is starting to become entrenched more generally -- and that this, in turn, is a result of India's economy growing faster than it can sustain.
Look at the current account deficit, which widened sharply in the September quarter, and which Goldman Sachs estimates will hit 4.3 per cent of GDP in the year ending March 2012. Overall wholesale price inflation in November was 7.5 per cent. Some economists also think India may be in the early stages of a wage/price spiral.
Apologists point out that it is only natural that wages should rise in such a rapidly growing economy; and that as Indian diets get richer, the prices of items like milk and meat will rise. It is certainly healthy for the country to experience big shifts in relative prices. But that doesn't mean it should be happy with sharp increases in average prices -- especially since global inflation is also on the rise, and India will be badly hit by high crude oil prices.
The Reserve Bank of India, the country's central bank, has tightened monetary policy following the dramatic loosening in the wake of the global financial crisis. The government has also reined in fiscal policy. But with the repo rate at 6.25 per cent, real interest rates are negative; and the general budget deficit, which includes the states as well as central government, is expected to end the current financial year at a fairly high 7.5 per cent of GDP.
Both the central bank and the government will probably apply further light touches to the brakes when the quarterly monetary policy review and the budget are announced this month. But there doesn't seem to be much urgency to get ahead of the curve. This is largely because the government has become addicted to the country's near-9 per cent growth rate. Indeed, some influential voices now argue that a medium-term inflation rate of 6-7 per cent would be a reasonable trade-off if that is what is needed to sustain fast growth.
Such thinking is misconceived. There is no medium-term trade-off between growth and inflation. If a country is growing at above its productive potential, as Milton Friedman rightly argued, inflation will accelerate: the 4-5 per cent inflation policymakers previously thought reasonable will become 6-7 per cent inflation and then 7 per cent plus, which is where inflation has been stuck for over a year. If inflationary psychology gets entrenched, it will be expensive to uproot. International investors, on whom the country relies to finance its current account deficit, could also take fright if they perceive the authorities have a cavalier attitude.
India may well be able to sustain 9 per cent GDP growth over the next decade, but only if it presses ahead more vigorously with supply side reforms -- to combat corruption, free up labour markets, boost infrastructure investment and the like. In the meantime, it would do better to settle for lower growth. It would also be advisable to strengthen the independence of the RBI, which is susceptible to interference by politicians, and set a formal inflation target. Otherwise, there will always be a temptation to play politics with inflation.
India's wholesale food inflation rose to 18.3 per cent for the week ending Dec. 25. The previous week it was 14.4 per cent. The increase was driven in part by a sharp rise in onion prices.
Overall wholesale price inflation was 7.5 per cent in November, down from 8.5 per cent in October. The Reserve Bank of India is currently forecasting that inflation will drop to 5.5 per cent by end March.
The RBI's third-quarter review of monetary policy, which is expected by many analysts to include an increase in interest rates, is due on Jan. 25.
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