The inflation bug

While making a tally of the achievements of his government during the past seven years, prime minister Manmohan Singh also made a list of the challenges that it still faces. At the top of the economic list was its failure to control inflation. Since the prime minister prefers circumlocution to direct speech it is not always possible to decipher precisely what he has in mind. Was this an admission of helplessness before a new kind of inflation to which no one has as yet found a cure, or was he simply saying that despite trying a variety of remedies his government had not yet found a remedy for the disease?

If it was the latter, then the prime minister’s admission has to be read as an indictment of the Reserve Bank of India, for ever since December 2006, it has not merely made the control of inflation the centre-piece of its monetary policy in every quarterly meeting, but has insisted that it and it alone has the final responsibility for doing so. The other branches of government were welcome to use fiscal measures such as the reduction of import and excise duties or administrative measures such as deferring oil price hikes to soften the impact on consumers, but actually controlling its root causes was the bailiwick of the RBI.

For four-and-a-half years the RBI has tried to do so using the only weapon it has — the control of money supply. And money supply can be controlled only by raising certain key interest rates. To say that its failure has been complete would be an understatement.
Just spare a glance for these figures: Between January 2007 and August 2008 the RBI raised  the bank rate from 6 to 9 per cent. This brought the rate of growth of money supply down from 23.5 per cent to 20 per cent, in spite of a sharp countervailing rise in the inflow of foreign exchange into the economy.

Prime lending rates rose a full 2.25 per cent to 14 per cent, the equivalent of 8.5 per cent in real terms or 5 per cent higher than in any mature economy anywhere in the world. Not surprisingly investment plummeted and the industrial growth rate fell from 12.4 per cent in the first quarter of 2007 to 5.2 per cent in the second quarter of 2008.

Shouldn’t such a sharp squeeze on money supply, and decline in production, have curbed the inflation the RBI claimed it was fighting? But lo and behold, inflation rose from 4.5 per cent in January 2007 to 11.5 per cent in June 2008! So much for the RBI’s expert management of the economy.

Knowledge proof economists

One would have thought that the RBI would have learned something from this fiasco, but apparently its ever changing cohorts of economists are knowledge proof. For in 2010, when the inflation rate went into double digits again for the first time after the recession, the RBI began to worry about inflation once again and in the next 15 months raised various inter bank interest rates no fewer than eight times to curb the growth of money supply. In this it was supremely successful: with little or no hot money flowing into the country money supply grew by an average of only 15 to 16 per cent in 2010-2011. But inflation stayed happily at an average of 9 per cent or more throughout the year.

What the RBI did manage to do was to once more kill the industrial boom. It began to cut down credit just as the economy finally pulled out of its short-lived recession. Between January and April 2010 industry had clocked a 15 per cent growth rate. Less than a year later this fell — between November 2010 and March 2011 to an average of 4.2 per cent.
If prime minister Manmohan Singh wants to control inflation, he will do well to get the RBI out of the picture and concentrate on tackling the causes of the endemic supply shortage of sensitive food items that is the relentless driving force of the inflation today.

The price of fuels is in no one’s control today. But the solution, which is to switch to transport fuels made from biomass residues such as black liquor, bagasse and rice husk, have been tested to death in laboratories all over the world and found to be highly profitable. To cite just one example, in a very short while most of the aviation jet fuel the Arlanda Airport Authority, which runs Stockholm airport, will be selling will be made from wood pulp residues. This ATF is expected to cost about a sixth less than the aviation fuel obtained from oil refineries.

But the main challenge lies in increasing the output of sensitive food products, whose shortage is the main cause of the inflation we have suffered since 2010. These are fruits and vegetables, dairy, livestock and poultry products, the demand for which is being pushed up by the rising affluence.

If Dr Singh wants food prices to moderate this year and not show the huge jump in the coming six months that we witnessed last year, he will do well to channelise their exports through state agencies or even ban them as an interim measure till better roads, crop insurance and cold storages can facilitate a further rise in the areas under fruits and vegetables.