Inflation: Don't overreact

Starting the delayed mining projects and inter-state farm trade will help more than raising interest rates.

Inflation, inflation, inflation — the bugbear refuses to go away. The central bank raised its estimate for the wholesale price index (WPI) to 8% for March 2011, up a percentage point since its last estimate in January. Recall the first estimate for March-end inflation given last April was actually 5.5%, so even though inflation has declined over the past year, the fall has not panned out as anticipated. This has largely been due to inflation in primary articles, first in food articles and now in non-food, and these pressures will continue.

Our research shows that price increases are spreading across the economy — and perhaps more in the unorganised sector than in the organised one. Wages are rising for semi-skilled and skilled workers far above the NREGA norms, growth in eastern India has reduced availability of unskilled labour, and real estate prices are on the uptrend across rural and small-town India. Profitability will take a hit at least for the next couple of quarters. The recent uptick in inflation in manufactured products is, therefore, expected to continue in the next quarter to peak around 6-7% by June, stabilising about a percentage point lower by the year-end.

These estimates, of course, depend critically on how fuel and commodity prices move. Looking at the crude trend, the unrest in west Asia has already pushed prices up by about $15 a barrel and, while it is acknowledged as a short-term phenomenon, it is not clear how long this will last. China and India have again been held to account for the rise in input prices with strong growth. Both countries have upbeat reports from the PMI survey, which for March shows continued flow of new orders, more so in India.

Both countries have been raising rates at a moderate pace as growth has taken precedence over inflation, but this stance could change by June: while inflation in China has recently steadied, pressures continue to reign in India.
Over and above the inflation concerns are the growth concerns. What is the Reserve Bank of India (RBI) to do? This is a tough call for the RBI as over-reacting would impact the growth sweet spot that India is in. Our advice to the RBI would, therefore, be to restrain itself in rate increases for the coming few months even if international commodity inflation rises by a few percentage points.

To put it in another way, if the government does act by its Budget promise of reining in expenditure, increasing interest rates and tightening liquidity can impact growth and growth expectations more adversely than in the past, or is desirable. There are other issues to address as well. If we look at the credit side, the rate hikes so far have not dampened the spirit of consumers or producers. According to the latest provisional RBI data for February, credit flows in all segments, except agriculture, have grown at a faster rate than the previous year.

Yet, there is cause for concern: unlike other segments, credit to agriculture and SMEs is not gaining in growth. Clearly, structural issues in access to credit continue to bog down the two sectors and this inequality in access should be dealt with urgently. The point being made here is that we should not be carried away by the 9%-plus growth path in India, a sustained growth path with equitable distribution of benefits calls for more than just multiple welfare schemes.

In other words, what is needed is more action from the government; to take just two points, it would do well if it kickstarts the delayed mining projects and enables inter-state farm trade. Such moves will do far more for growth and inflation in the long term and are long overdue. Welfare and financial inclusion initiatives may be well and good, but they cannot by themselves get us to the impressive objectives we have set ourselves.