Monetary, fiscal and supply-side policies need to tackle price rise in tandem.
Inflation has raged unabated for the past five years — it started to decline earlier this year but picked up again in March. While there are many unanswered questions, it is clear that a simplistic inflation-targeting approach — a euphemism for stabilisation first and growth later — which is favoured by the IMF, has failed and will not work in India. We need a more comprehensive approach that will revive growth and lower inflation simultaneously.
As in most emerging markets, India’s growth rate has also declined. However, since 2010-11, India’s decline in growth has been twice the emerging market average. So, about half the decline in our GDP growth rate is attributable to factors unique to India.
But given the low rate of world inflation, India’s price rise remains a puzzle. When India was a closed economy, its inflation was higher than the world’s when shocks to the economy were largely domestic. And lower, when shocks, such as the oil price spike of the 1970s, were external. But today, with a largely open economy and capital account, it is hard to understand the persistent high inflation, especially when, in contrast, the world has been worried about deflation. There are three broad explanations for this.
First, India recovered quickly from the 2008 global crisis because of large fiscal and monetary stimuli. But these were maintained for too long and fuelled inflation. With a mostly open capital account, foreign inflows increased sharply, the real exchange rate appreciated and the current account deficit widened to dangerous levels. A consumption boom followed, and wages and the prices of land and services went up sharply. The RBI started tightening monetary policy in late 2011. But by then, it was too little, too late. The economy was also slowing down and the aggressive tightening had to be tempered to avoid hurting growth further. But core inflation still rose, and some argued that a more aggressive monetary stance was needed to break high inflation expectations.
But the loose fiscal policy continued in spite of the monetary tightening. Moreover, the composition of government expenditure tilted away from investment towards public consumption, due to the sharp increase in subsidies. Programmes like MGNREGA channelled money into the hands of the poor, and caused rural real wages to increase. Consequently, the demand for and prices of food both increased. This in turn caused wages to rise. A wage-food price spiral fuelled inflation further. Similarly, as incomes of the non-poor rose, their consumption shifted from grains to proteins, oilseeds and vegetables, whose prices rose sharply. With high government expenditure and the announcement of a new pay commission, the continued…