Rahul-flation won't be killed without double-dose rate hike

Duvvuri Subbarao is unlikely to have a good night’s sleep tonight. The next monetary policy review is scheduled for tomorrow (25 October), and the Reserve Bank governor is under political and business pressure to go easy this time.

The advice is almost 3:1 against any further increase in rates. At best there is a grudging belief that, maybe, he ought to do just one more hike of 25 basis points (0.25 percent) and then forget all about it, never mind where inflation is.

The arguments of the no-rate-hike-wallahs are two-fold.

One, despite 12 consecutive rate hikes, inflation hasn’t come down. Instead, growth has slowed, and we now have the worst of all worlds - high rates, high inflation and slowing growth.

Two, since inflation is largely a supply-side phenomenon - no amount of rate hikes can bring down food prices since that depends on higher food output, not interest rates - raising rates to bring down inflation is like cutting off your nose to spite the face. Or, choking off growth to strangle inflation.

[caption id=“attachment_115467” align=“alignleft” width=“380” caption=“Duvvuri Subbarao is unlikely to have a good night’s sleep tonight. The next monetary policy review is scheduled for tomorrow (25 October), and the Reserve Bank governor is under political and business pressure to go easy this time.PTI.”] [/caption]

That is the dove position, and nobody makes this case better than Surjit Bhalla, who heads an emerging markets advisory and fund management firm called Oxus. According to Bhalla, Indian inflation is directly related to food procurement prices, which he demonstrates through a chart in his column in_ The Indian Express ._ He says there is a “close correspondence” between procurement prices and inflation, and notes “the economically criminal vote-getting policy of the Congress after it came to power in May 2004” in this regard.

Between 2006 and 2009, says Bhalla, “the relative price of food increased by a record 33 percent” and this is what has led to “high and sticky inflation in India.”

We are in agreement with this assessment, and this writer has called the resultant inflation Rahul-flation - since it is geared to putting the first family’s political goals ahead of economic good sense.

The Congress, obviously cannot agree with this assessment, which is why it is pressing the RBI to lower rates. The same applies to businessmen, who are balking at the rising cost of money. Home buyers, and anyone with access to credit - barring savers - will be unhappy with the high interest rate regime.

This is why the doves are in the ascendant, and there were very few hawks left in the monetary space.

One of them is SS Tarapore, a strong monetarist and former Deputy Governor of the Reserve Bank of India (RBI).

Tarapore’s argument is as simple as that of Bhalla’s: he believes that Subbarao made a mistake in not raising interest rates fast enough in 2009-10 - when inflationary expectations were building up. But now that it is clear that the RBI missed the bus, should it pause on rate hikes because it has been ineffective against inflation?

Tarapore’s answer is a roaring no.

“Such a move would be disastrous, as inflation can get totally out of hand. The longer the RBI delays strong policy action the more inflation gets entrenched in the system,”

Writing in BusinessLine, Tarapore’s advice to Subbarao would be to not only raise the repo rate by 50 basis points (0.5 percent), but also crimping bank liquidity by another 50 basis points through a hike in the cash reserve ratio. (Repo is the window through which the RBI lends to banks, and CRR is the money banks have to keep with the RBI at practically no interest.)

With strong advice from the doves and hawks, what should Subbarao do?

This writer believes that the RBI will risk losing whatever credibility it garnered this year by giving up on the rate hikes. Actually, there are two reasons why Subbarao should listen to the hawks - at least this time.

One reason is the need to maintain the credibility of past actions when inflation is near double-digits. The other reason is to send a strong message to policy-makers that fiscal policy is a mess - and till this is corrected, monetary policy cannot ease.

In fact, Bhalla calls the Congress efforts to boost food inflation through an overdose of procurement pricing “criminal”. Easing interest rates before inflation is down is like rewarding this economic criminality.

In the past, this writer has argued that the main cause of inflation is the Congress’s primary political goal of getting Congress re-elected and bringing in Rahul as PM through economically dangerous giveaways. We have called the resultant inflation Rahul-flation.

The RBI should not reward Rahul-flation by pausing its rate hikes. It should opt for a 0.5 basis points hike tomorrow. Bad politics has to be killed with good economics and hawkish monetary action.