Raising interest rates is not a sustainable solution to tempering inflation
The 12-13% Wholesale price index (WPI) inflation in India is usually blamed on two things: higher energy prices and higher crude. If you look at food prices, they’ve only increased by 6.2% this year. Crude has gone up by 16.5% but these prices have not been passed on to consumers as it is being subsidized by government. So where are these 12% plus inflation figures originating from?
The culprit is manufactured goods. Inflation here is running at 10.8% - this despite the fact that industrial growth has slowed. In April, the year on year (yoy) inflation was 6.2%, and in May this fell to 3.8%. This begs the question – why are prices increasing so much if growth is so muted? And if you cannot blame oil or food for rising input costs what can you blame?
The answer lies in the fact that there are supply side constraints and inefficiencies. You can see it everywhere – the traffic on the roads, the crowded airports, electricity cuts, a shortage of skilled labour, and water shortages. Electricity consumption only grew by 2.3%, and clearly it’s not like there isn’t a demand for electricity. There is more than sufficient demand, but the supply of electricity cannot keep up. When supply is not able to match up with demand, then only one thing can happen, and has happened – prices have gone up.
In my opinion therefore, raising interest rates to throttle growth is not a sustainable solution. Once inflation cools, interest rates will fall, and demand for goods and services will rise as it becomes cheaper for companies and individuals to fund consumption and investment by borrowing. Very quickly however, as demand rises, we’ll be back to square one – because once again there won’t be enough capacity to meet that demand. Inflation will increase, and we’ll again be in a cycle where interest rates have to be increased.
The only answer therefore, is reform, better government planning: build roads so that it not only meets demand today, but also tomorrow and day after – and huge amounts of fuel is not wasted as cars and trucks burn it away sitting in traffic. Allow private sector schools and universities that can operate for profit, so that both the volume and the quality of skilled labor increases.
Not many people know this but contrary to popular belief, India is a resource rich country. We have the largest bauxite (aluminum ore) reserves in the world. We have the third largest coal reserves, and iron ore reserves in the world. However, my understanding is that there are still huge roadblocks in expanding capacity in these sectors: licenses to obtain, palms to be greased and favours to be done.
Supply side reforms require two things – guts, and time. Even if you assume a gutsy government, committed to reformist policies and increasing transparency, it still takes a long time for the impact of these policies to become visible. This is why governments are sometimes reluctant to push such reforms through – if they don’t get put back into power, it will be the next government that will enjoy the fruits of somebody else’s labour. This is why the only practical solution is the short term one – playing around with monetary instruments to keep inflation under control. We can only hope that by the time aggregate demand starts recovering the next time around, there has been a sufficient expansion in aggregate supply to keep inflation at bay.
Tags: Aggregate Supply, Commodity prices, Crude, Crude Oil, Equity, Finance, Food Prices, inflation, Interest rates, Monetary Policy, Reforms, Supply Side Reforms
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