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We Won’t See Rate Hikes Stopping Soon


Deepak Mohanty, ED at the RBI talks about inflation and its dynamics. I’d like to discuss part of that article, where he talks about the Inflation trajectory and how it will be determined – and make a case on timing. All emphasis is mine.

[Warning: LONG post]

Five factors will shape the inflation trajectory. The first is the trend in domestic food prices. Given the current stage of our economic development, the demand for food items, particularly animal protein, will increase with economic growth and a rise in income levels.

The demographic dividend, which has been contributing to our growth and productivity, has also raised consumption demand, particularly food.

As per a United Nations projection, a high consumption cohort in India’s total population will continue to dominate demand till 2040.

On the other hand, current per capita availability of cereals and pulses has been lower than that in the previous five decades. Oilseed production falls far short of demand.

Food prices in India are primarily determined by domestic demand and supply factors, and domestic price policy. With India’s domestic food prices being higher, import is not an option for reducing the prices. Hence, increasing agricultural productivity and expanding livestock production will be important for moderation of food inflation.

There are more issues with this.

1. We have a “minimum support price” for many agricultural items, and they have been given a 10% increase every year. This is the price the government pays for foodgrains, and you can expect that this is the lower limit for an annual increase in what comes to us.

2. Despite food rotting in its warehouses, the government wants to procure more food and hoard it in the name of a food security policy. Given that our productivity increases in agriculture aren’t that much in the first place, this idea itself will create supply shortages, which will drive up prices.

3. We disallow or discourage import of many foodgrains (or indeed, export of some). Free trade will help balance out prices in the longer term – however if other countries like the US heavily subsidize their farmers (more than us), high duties will be the only way to get a real counterbalance.

4. We don’t allow corporates or “non agriculturists” to become farmers. That takes away the much required capital that can really revolutionize farming.

Not only will this not get fixed in the near term – there is no political will, and farmers are a large vote bank – there is evidence we will go in the opposite direction.

Second, global commodity prices and, particularly, crude oil prices will have an impact on overall inflation. This requires policy initiatives towards energy conservation, efficiency in energy usage, recourse to alternative sources of energy, and step up in domestic exploration of oil and gas. For a fast growing economy such as ours, energy supplies will tend to lag demand.

It is, therefore, important to contain demand by letting the pricing mechanism play its allocative role. For this, it will be desirable to make further progress towards deregulation of petroleum prices, particularly diesel. This will not only allow the price signals to operate, but also balance the demand for petroleum products.

First, energy conservation is just not going to happen, or help. Asking people to switch off lights or geysers, or consume less, is horribly counterproductive – we have a country where too many people never even had electricity and they will slowly start getting connected to the grid. And with weather being extreme in most parts of the country, fans and A/Cs and heaters will be the norm – as they must be, because we have lost too many people to vagaries of weather. Net/net, the efforts to conserve power will be miniscule and led with silly tactics like switching off power for one hour (it won’t make a flying F of difference). The most efficient way, unfortunately, is load-shedding – and that, we’ll all agree, is retrograde.

Power is not stored – the minute it is produced, it has to be used. Much of it is lost along the way from the power plant to you. There is theft as well. There are ways to make this less inefficient but we haven’t invested in much. Even if we did, it would take years before we are able to; again, this is not a near term solution.

Alternative sources: only nuclear can provide the kind of power we need. Yet, we have all sorts of very intelligent people opposite really high quality nuclear power projects, even when we can get independent through thorium based reactors in the next two decades.

For cars, we have only crude oil based stuff – though it’s strange why we wouldn’t pursue a better CNG based solution (CNG has HUGE distribution issues). Even if CNG is a fossil fuel it seems there is more of it that we can harness, especially if we can get it from under shale rock.

Deregulation of diesel has to happen. But it won’t, as long as this government is in power because the folks out there are complete sissies. So, forget that bit.

Third, on the demand side, there is a need to shift aggregate demand away from consumption towards investment, to augment the potential output of the economy. The demographic dividend that we have in terms of addition of younger people to the labour force could be better harnessed when combined with increasing capital accumulation.

If the potential output does not expand, and the economy tends to grow faster than potential, it will result in overheating. The resultant inflationary pressures, by itself, will impact growth adversely. It is, therefore, important to enhance the potential output to dampen the inflationary impulses.

Essentially, he says that we must use our money productively – for example, instead of buying ipads, find a way of making ipads, so that ipads become cheaper. This will take tons of time, and the improvement in productivity can’t happen if you have rules stopping you. You need 7,000 permissions to start a business (I’m kidding, it’s only 6,500). You can’t fire people. You can’t become a better farmer because of lousy land laws and restrictions. You can’t get money from foreigners to invest into certain sectors. You can’t use biotech for better seeds, for the most part.

Look at the state of our colleges. We have IITs and NITs, but hardly any world class educational journals, campus research output or inventions coming from colleges. We don’t encourage our colleges to think about stuff that’s 10 years ahead – which, I hear, is the norm in the US. Education is primarily a business now, and the idea is to churn out well-mannered, job-wielding graduates. A whole generation of people has been lost to the IT coolie market whose idea of innovation is a web site that gives you discounted massages. This is skewed productivity. We need across-the-board innovation. Sure, some of it is happening, but our policies on education leave much to desire.

As an example, think of the number of innovations you have HEARD about in refrigeration, for India. Or in farming techniques or irrigation. Or water based transport. Reports have been very scarce lately.

Again, not only is this not possible to change in the short term, but there is no plan to change any of this at a policy level. A pockets of excellence we see is Gujarat – where there is fabulous governance.

Fourth, the level of the fiscal deficit and the quality of government expenditure have significant influence on inflation. Under normal circumstances, when p
rivate demand is buoyant, expansion in the fiscal deficit could be inflationary. Since private borrowing competes with government borrowing, it could exert upward pressure on interest rates. This could crowd out private investment, which would have an adverse impact on the overall economic growth.

Further, it also matters whether the government borrowing is for financing consumption or investment. The fiscal multiplier works better with investment, but a rise in government consumption expenditure could be potentially inflationary. There is, therefore, a need to move towards credible fiscal consolidation to contain demand-side pressures on inflation.

Oh this is fun. Without the 3G spectrum sale, or any serious disinvestment this year, the government’s accounts are in shambles. Watch the fiscal deficit till August:


We’re up 122,000 crores from last year, and the gap is likely to get wider. Not addressable in the short term and given our oil bill and two more elections next year and the government’s likelihood of giving sops to buy votes, this is not going to change in the short term.

Fifth, the stance of monetary policy and its ability to anchor inflationary expectations will affect how inflation evolves in future. The level of the policy interest rate should be such that it is neither too stimulative nor too tight.

This requires active liquidity management by RBI so that the systemic liquidity mostly remains in deficit in order to strengthen monetary transmission.

This is a key point. But with credit growth over 20% and money supply growing at 16-18%, we are focusing only on interest rates. Given our productivity challenges, we must keep money supply growth low – for which if reserve ratios need to be raised, some of our dollars need to be sold etc. (Read: Why only interest rates? and Stop Buying Dollars to Curb Money Supply)

Again, this is unlikely in the short term (though this policy can change fast) and also there is limited will for it within the RBI.

In all the cases above there is

a) no chance of a structural pause in inflation (other than some small spikes controlled)

b) little or no will to take strong measures to help.

If all the heavy lifting will have to be done by interest rates alone, we are likely to see double digit interest rates (10% to 12%) in the near future.


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