mahikarnam

Rising inflation in the last few weeks — not so much the level of inflation as the trend of increase — poses a major challenge to the government.

The Indian economy in the past has withstood higher rates of inflation and a 7.5 per cent inflation today would not be a great problem if it did not threaten to precipitate an even higher rate of inflation tomorrow.

There is no time for bickering about who is responsible for this situation and who must accept the blame. Politicisation is no solution to the problem. The cost of this inflation may turn out to be extremely damaging to the country’s growth and common man’s welfare.

We must prevent the rise in inflation into generating wide-spread inflationary expectations that would in turn raise the level of inflation further. This could precipitate a serious crisis with loss of confidence in the domestic currency and both foreign and domestic savers moving out of domestic assets and investments.

The crisis can go out of hand very soon, unless measures are taken to reverse the expectations about continuing inflation, raising confidence among investors and asset-holders about the ability of the government to control inflation.

For that, nothing can be more effective than the stringent measures by the Reserve Bank of India (RBI) to control liquidity and suppress demand.

Even if the proximate cause is constrained supply, controlling liquidity and managing demand would always bring down the prices. The cost of that may sometimes be too high when suppressing demand leads to not just fall in prices but also in growth of output and employment.

An early intervention before inflationary expectations grip the situation, a modest reduction of liquidity may be sufficient to reverse this process. So the RBI’s attempt to squeeze liquidity is a policy in the right direction. Raising the cash reserve ratio (CRR) may unnecessarily affect the profitability of the banks, having cash without returns.

When the aim is to reduce expenditure, a straight forward increase in the rate of interest could be a preferred option, provided complementary policies are taken to neutralise its effects of increasing inflow of foreign capital, in search of higher return. If the RBI does not intervene to buy up dollars, the rupee would appreciate reducing exports and through that, the growth of output of employment, in addition to the negative effect of raising interest rates.

But that is the cost that may have to be accepted. Otherwise the RBI’s interventions to prevent such appreciation could only increase the liquidity further. A preferred policy may be to control inflows of such foreign funds either by imposing a Tobin-type tax by raising taxes on short-term capital gains.

The fine-tuning of reducing liquidity at the minimum possible cost of output and employment is the art of financial management. However, controlling the cost-push effects of inflation depends entirely upon the political economy. India has been substantially globalised not to be able to insulate itself from the cost-push of steeply rising global prices of petroleum, metals, raw materials and essential items of consumption.