Inflation at 2-yr high, heat on interest rate

Since oil prices are based on global factors and commodity prices of primary articles get affected by short term factors and are often highly volatile, many countries look at “core inflation.” Core inflation basically means excluding the prices of these two highly volatile components from the inflation figures.

Even if that’s done, inflation based on prices of manufactured goods, a measure of core inflation, rose by 5.9%.

Finance Minister P. Chidambaram said the inflation numbers are a matter of concern and the Government would take steps. “Inflation is a monetary phenomenon and is also being driven by supply-side constraints,” he said. “The Ministry of Finance is in touch with the Reserve Bank of India and Agriculture Ministry, and we will do whatever is needed.”

Former RBI Governor and chief economic advisor to the Prime Minister C Rangarajan said, “The trend was in the direction of inflation accelerating. If inflation rises beyond 5.5%, it’s a matter of concern and can cause problems in the exchange rate.”

Concerns have been expressed that the Indian economy, with its high growth rate and rising inflation rate, high real-estate prices and rising salaries, is overheating. Ratings agency Moody’s said as much this week adding that capacity constraints could prevent annual growth of 9% from being sustained.

The difficult question is what to do about the “overheating” if it is indeed happening. While on the one hand, raising interest rates would help contain inflation, on the other, it would slow down growth.

However, despite the danger of being accused of spoiling the party, keeping rising inflation in mind, in recent months the RBI has taken a number of steps to tighten monetary policy.

Interest rates — the repo rate and the reverse repo rate — have been raised and the Cash Reserve Ratio has been hiked.

This would suck liquidity out of the banking system and reduce the availability of credit making it more expensive to borrow. But the latest inflation numbers may not necessarily mean that more interest rate hikes may follow immediately. The impact of interest rates on inflation is never instant. It usually happens with a lag. The tightening done by RBI may not have an impact on prices for up to six months. Usually a gradual approach that gives a clear signal to the market that the Central Bank is prepared to raise rates if inflation continues to go up is more effective than a sudden sharp rise in rates. Interest rates are important in giving signals to markets and therefore in curbing inflationary expectations.

Until recently, the impact of higher rates on actual credit availability and bank lending in India was low because banks were holding more government securities than they are required to. To increase lending, they merely had to run down their stock of government securities. Thus, demand for credit for investment or consumer expenditure could be easily met.

Now that the stock of government securities with banks has declined to the SLR (Statutory Liquidity Ratio) levels of 25 percent, any increase in lending will have to come about only when banks borrow more. The impact of small changes in interest rates will be much higher than it has been.

Further, an appreciating rupee can also help curb prices. If there is global pressure on the dollar to depreciate and the RBI allows the rupee to become stronger by not intervening in the market, imported goods become cheaper. Refraining from market intervention also keeps liquidity in the system under control again helping in curbing inflation.

The combination of a rising rupee and small rises in interest rates could effectively curb inflation in the next few months.