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Friday, 28 January 2011 00:00
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If seven interest rate hikes between March 2010 and now, by 175 bps in the case of repo rates and 225 bps for reverse repo rates, haven’t helped curb inflation levels, it would seem to suggest that monetary policy has just that much of a role when it comes to curbing inflation. While the higher end of bank loans, for consumption spending, has seen interest rates rise from 18% in March to 25% by September (according to RBI data), inflation remains at fairly high levels and has risen from 7.5% in November to 8.4% in December. Though interest rates are not the only factor influencing the index of industrial production, it is worth keeping in mind that IIP growth fell from 22% in March to less than half in October.

 

It is in this context that the advice given by Raghuram Rajan, the honorary economic advisor to the Prime Minister, needs to be taken seriously. Speaking to FE at Davos, Rajan added that if you hike rates too much, this will kill growth. None of this is to suggest RBI shouldn’t increase rates when inflation is getting out of hand or to prevent inflationary expectations from getting built up, just that fiscal policy will have a greater impact. In the last two years, for instance, private consumption expenditure grew by an average of 12.6% per annum as compared to 22.1% for government consumption expenditure—the numbers for 2010-11 show that the trends continue with government consumption expenditure picking up by 21.1% in the first six months of the year. As a percent of GDP, government expenditure rose from 15.5% of GDP in 2000-01 to 16.4% in 2009-10, so it is obvious a cut in government spending will go a long way in curbing money supply growth—in 2009-10, for instance, the increase in government spending equalled around 30% of the total hike in commercial bank credit to the non-food sector. No rate hike, unless it is large enough to choke off growth, can possibly result in as much of a slowing in credit growth as a slowing of government expenditure.

The other issue this newspaper has been making for a while is that inflation is directly related to capacity creation—by and large, production has been stagnant in the agriculture sector and this is where prices have risen the most. Matters are nearly the reverse in the manufacturing sector—at the extreme, production of the Maruti Alto rose 8 times in the last decade and, as a result, its prices fell a fourth. Any way you look at it, there’s a lot of work for the government, and the scope of play for Duvvuri Subbarao is limited.

 

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