The growth versus inflation dilemma

July 19, 2012

(The views expressed in this column are the author’s own and do not represent those of Reuters)

The RBI is concerned about inflation; the finance ministry has growth as its priority. That, as RBI Governor D. Subbarao mentioned, makes the two almost look like adversaries.

Subbarao has his reasons. “The relation between growth and inflation is non-linear,” he said, “and there is a threshold below which there is a trade-off between growth and inflation. But above the threshold there is no trade-off.”

What he means is that a little inflation is good for growth; but when inflation exceeds a critical level inflation can actually come in the way of growth. The RBI believes that the present level of inflation is beyond that critical level and has therefore focused on controlling inflation using the repo rate as the main policy instrument.

But inflation has proved too hard to crack. Already, it is two-and-a-half years since the RBI has been working on inflation. It was in March 2010 that the RBI increased the repo in quick steps from 4.5 percent to 8.75 percent. But inflation did not respond. Meanwhile, GDP growth dropped from 9 percent to 5.3 percent.

The fall in GDP growth has been almost exclusively due to the stagnancy in industry. While agriculture and services more or less maintained their pace, industrial growth dropped sharply. Industry is driven by demand. When demand is strong, it will use capacity fully and go in for additional investment. When demand is weak, production is reduced.

In 10 out of 22 industry groups in the manufacturing sector, production declined in May. Investment in new projects dropped from 3.1 trillion rupees in the quarter ending June 2011 to 1.9 trillion rupees in the quarter ending June 2012.

Presently, we have a strange combination of inflation and stagnation. But look at inflation. It is taking place predominantly in the agricultural sector. And look at the slowdown in production. It is predominantly the industrial sector. Why?

The reason is simple. It is because the rise in prices of agricultural consumer products, for which demand is very inelastic, diverted a part of consumer expenditure from industry to agriculture. Demand for industry dropped and it was forced to cut production.

It is no wonder that the repo rate failed to curb inflation. Although inflation was subdued towards the end of 2011 and the beginning of 2012, it was because agricultural production, particularly of fruits and vegetables, improved and reduced the mismatch between demand and supply. That is the solution, not repo.

That raises another question. If an increase in repo failed to curb inflation, would a cut in repo pull up industrial growth? Perhaps it would. Not because the consumer expenditure on agriculture will be reduced but because the lower rate of interest will divert a part of the income from savings to consumption. Demand for industrial goods will revive and growth will pick up even though inflation is beyond the threshold level. The RBI should therefore give greater weightage to growth in its quarterly review on July 31.

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