Inflation: limitations of monetary policy

Inflation which is a kind of regressive taxation, points to a situation in which "too much money chases too few goods". This is the result of the operation of the demand-pull theory of inflation - when aggregate demand exceeds aggregate supply. Inflation erodes the real value of money, discourages saving and poses multiple problems for cash-strapped consumers. Its impact on planning for economic development is very upsetting.
The recourse is found in the application of monetary policy which uses higher rate of interest as a tool to contain aggregate demand and resultant inflationary pressure. As against demand-pull theory of the monetarist, another school of thought argues that a generally abnormal price hike in a developing economy is caused by the short supply of goods in the wake of low production or higher cost of production, emanating from mismanagement in the economy. So the inflation could be the outcome of either demand-pull or cost-push factors.
The country has been expressing double-digit inflation for the last four years. According to latest data of the "Economic Survey", the cumulative rate of inflation rose to 14.l percent in FY-11, food remained the major driver of inflation being l8.4 percent, (according to a study, a rise in food inflation deteriorates the poverty situation by 2.7% points). A 16.5 percent rise was witnessed in the transport sector, followed by the energy sector 14.7%, the medicine group 14.5% and the textile sector by 11.7 percent.
During the fiscal year 2010-11 as well as in the current fiscal year, the high policy rate (discount rate) was l4 percent and the lowest was l2 percent, which is still continuing. As against this, the average lending rate remained at 13.55 percent and the deposit rate at 5.97 percent, which resulted in a spread of 7.58 percent, as is evident from the bulging profit of banks.
Government borrowing in July-April, 2010 stood at Rs 342 billion; in addition to Rs 26 billion to the public enterprises. The share of the private sector was Rs 156.7 billion. The total public debt which stood at Rs 6.04 trillion in June, 2008 surged to Rs 10.996 trillion by the end of first quarter of the current fiscal year, in violation of fiscal responsibility and the debt limitation act 2005, which seeks to contain both public expenditure and public debt within a well-defined limit. Despite this, however, the circular debt could not be fully retired and the fiscal deficit during the current year is likely to cross the level of 7 percent of GDP.
The shortfall in the domestic production of essential food items, including tea, sugar, edible oil and pulses was met through their costly imports. The unplanned exports of items falling in the category of food groups, including meat and meat preparations, fruits and vegetables caused shortages in the domestic market and the consequent rise in the prices. The persistent rise in the petroleum prices after periodical intervals has been a perennial source of cost-driven inflation.
Meanwhile, the current economic scenario continues to be depressed in the wake of declining both national and foreign investment. The total investment has declined from 22.5 percent of GDP in 2006-07 to 13.8 percent in 2010-11. Likewise, no serious and concrete efforts, on the part of the government are discernible to contain the tempo of growing wasteful expenditure and ultimately escape from the curse of deficit financing. It is indeed difficult to mobilise additional revenue, by taxing a sagging or stagnant economy, with around 40% people living below the poverty line.
The State Bank has, however, again opted to keep the high rate of interest at 12 percent which will not help to reduce the public debt but will harm the private sector, which has already been badly afflicted by the acute shortages of electricity and gas, their high tariffs, deteriorating law and order situation and political instability. In fact, there are reports of relocation of industries to Bangladesh, Dubai etc. Such an abnormally high cost of doing business has not only rendered the fresh investment unfeasible, but has posed additional problems to utilising the full capacity of existing industries.
In fact, the role of a higher rate of interest as an anti-inflationary tool is limited in our country because it has still a vast non-monetized sector, where the change in the rate of interest or quantity of money does not have any impact on the nature and level of economic activities and specially on the demand of goods and services. Secondly, the proportion of credit to money in the monetized sector remains too low that the rate of interest fails to break the status quo. Thirdly, the success of monetary policy is conditioned by its operation in conjunction with a well-managed fiscal system, which is not the case. A prudent banking system will never envisage a rate of interest, which is either equal or higher than the prevailing rate of inflation. Such a strategy will end up rendering banking resources too costly and less attractive to investors. Already, the ever-increasing non-performing loans have outstripped the performing loans.
It can thus be safely concluded that the country has been experiencing acute cost-push inflation and the central bank must change its stance accordingly. Unless the government keeps its fiscal house in order, no amount of tight monetary policy could prevent the economy from being melted down. We must learn lesson from the deepening Eurozone debt crisis which has not yet averted or subsided despite the extraordinary fiscal and monetary stimulating measures because already damage has been caused beyond the repair. The State Bank, therefore, must take all measures within its purview to promote speedy economic growth, lest it is too late. As a first step, the rate of interest be rationalised and revised downward in the next monetary policy in order to fully revive the credit-demand of the private sector, the engine of economic growth.
(The writer is former KCCI secretary)