Should RBI raise interest rates?

Jahangir Aziz

RBI needs to strike a hawkish note and raise policy rates by 50 basis points. Anything less will only open up the very real possibility of a Hard landing

Here is the good news. Hopefully the December shock of food inflation jumping to 13.6%,and headline rising to 8.4%,will end the misperceived hypothesis that base effects and the winter harvest will bring down inflation to 6%,well on its way to reach 5.5% by March. Both events have come and gone and left policymakers in a tizzy.

Instead,as some of us have been arguing for a long time,the authorities will finally see the driver of inflation for what it is: an unsurprising consequence of loose monetary and loose fiscal policies pushing the economy to grow beyond its capacity. Agriculture clearly has no spare capacity and neither does services. With no investment having taken place outside infrastructure for the past two years,there is little in industry either. And the monthly momentum of non-food manufacturing inflation,the bellweather for monetary policy,has risen to 8% in December from 1% six months ago! True,nearly all the world is running loose policies,but these economies have massive excess capacity. We dont.

There is a widespread belief that food inflation is always a supply-side problem. In developed markets,income levels have risen to a point where food demand has stabilised.

Only changes in supply cause prices to change. This is not the case for a $1,500 per capita economy growing at 9%. Here food demand rises and quickly outstrips supply. Barring two months in the last four years,food inflation has never dipped below 5%. Separately,anecdotal evidence suggests NREGA payments have become the de facto minimum wage against which urban wages are being benchmarked. By linking this to inflation,government has institutionalised wage inflation and markedly reduced the ability of real wages to adjust to shocks.

So what are the policy options?

A lot. For starters,the runaway fiscal stimulus can be immediately scaled back,the agricultural distribution network reformed,and spending on agricultural infrastructure boosted. None of these will happen in a hurry. So RBI is left to do the heavy lifting.

It now needs to renew its vows to fight inflation through strong actions backed by strong words. It needs to raise policy rates 50 basis points and strike a sufficiently hawkish tone on inflation such that one is assured that the central bank plans to move ahead of the curve soon. Anything less will only reinforce the view that RBI will remain behind the curve over this cycle,opening up the very real possibility of a hard landing. If that were to happen,all the foreign and domestic investor interest in India would disappear in a trice and the 10% growth will remain just an aspiration. To the many in India,who argue that this will mean lower growth,heres a word to the wise: thats exactly what is needed. Indias growth far exceeds its capacity and thats the cause of high inflation. If inflation is to be brought down and medium-term growth safeguarded,near-term growth has to be sacrificed. The only choice is whether to sacrifice a little now or a lot later.

The author is India chief economist,JP Morgan. Views are personal