The Long View at Long Last

Inflation can distort investment and the overall allocation of resources in an economy

There is a new air of determination about Reserve Bank of India Governor Dr Duvvuri Subbarao, and it has shown up starkly in the Bank’s move on 3 May to up its repo rate (at which regular banks borrow from it) by half a percentage point to 7.25 per cent. This is the biggest hike since this rate-raising cycle began in March last year. Fighting inflation is clearly top priority now. “Current elevated rates of inflation pose significant risks to future growth,” as the RBI Governor put it, “Bringing them down even at the cost of some growth should take precedence.”

Last recorded, Indian inflation was nudging 9 per cent. This is the result of several factors, though analysts have pointed to domestic choke-ups in combination with global factors. “Rising input costs are increasingly spilling over to [retail] prices,” notes Leif Eskesen, chief economist for India at HSBC, “as strong demand conditions allow businesses to pass on higher costs more easily.” Worse, signs that runaway prices will attain stability anytime soon are weak. For the short-term, don’t count on the rate hike to offer much relief. “Its effect is limited to providing some cooling off of rising demand,” says Vikas Vasal, executive director at KPMG. Also, the Union Budget for 2011-12 means plenty of State spending, adds Eskesen, which leaves the RBI with the burden of taming inflation.

Inflation is best acted against pre-emptively, and now that it is already raging, it makes good sense to safeguard the economy for the medium/long-term. So, how is inflation bad for growth over a longer time span? ‘Uncertainty’ is the worry that Governor Subbarao has made a point of highlighting. This could hurt investment for the simple reason that it is very hard to make plans if one does not know the value of a currency’s purchasing power in the years ahead. So long as Indian firms keep their accounts in rupees, a stable currency is important.

What makes sustained inflation over a longish period even worse is the risk of prices failing to act as useful signals of demand and supply (to the extent they are useful in the first place, of course). With inflation raging, the prices of different items tend to rise in a relatively haphazard way. Too much of this, and it could distort the way resources are allocated all through the economy. Investment, for example, could rush into sectors with products artificially overpriced, falsely suggestive of surging demand. The result: gross inefficiency. India must not let such a scenario arise.

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