The problem our country is facing at the moment is the threat of high inflation. Apart from that it is important to reduce the government deficit as well. Question is whether it is possible to control the fiscal deficit and the inflation at the same time.
Recently, the RBI has consistently been going for contractionary monitory policies by increasing the repo and the reverse repo rates which stands at 7.5% and 6.5% respectively. This policy is intended to draw out money from the economy helping it to cool down. How? That is simple: The rising rates mean the banks have lesser money to lend and thus money is lesser for investments leading to lesser money flow in the economy and thus lowering inflation.
While this is a long term approach to tame inflation the contradiction to this policy is the raising of fuel and LPG prices. Theoretically, this leads to rise in the costs and is expected to eventually raise the prices in the economy fuelling inflation. But the government seems to believe it is not so. Their view is that higher price rise would also help to tame inflation by giving the consumer lesser money to consume. Their theory rests on the assumption that eventually decreasing the consumer expenditure would lead to lowering of aggregate demand and thus bringing down the prices in the market.
But it is almost always seen that when there is a rise in fuel prices it leads to direct impact on the supply side. The cost-push inflation leads the production cost to raise leading to eventual rise in the prices which again will be borne by the consumers. So, ideally the consumers will be affected on both fronts. Firstly, the direct impact due to rising of the gas and fuel. Secondly, indirectly as the producers partially transmits the burden on to them by including the rising prices in the final product. It has to be said that the government has taken adequate steps to protect the producers to some extent by reducing import and excise duties on certain important commodities because of which the government have to sustain heavy revenue losses. If this kind of subsidies are continued to be provided by the government then there is lesser scope of improving the government fiscal deficit.
One important concept that is required to be discussed right now is the policy lag. Now, whenever the RBI goes for any monetary policy there is a certain lag that thus exists from the day the policy has been announced and the time period when the policy actually starts to take effect on the economy. My argument is that if it was already expected from beforehand that the RBI is going to take contractionary steps then it might have already been incorporated into the prices even before the policy was allowed and thus the lag would cause further problems. On the other hand the unexpected rises in the prices of commodity prices like fuel will cause a direct impact on inflation fuelling it further. Eventually when the policy measures of the RBI would kick into the economy it might be so that inflation might have further increased. Thus, it will only cause the markets to settle back again at either higher than prices existing now or back to current prices, but will not do much to bring the inflation down. This is why the unexpected monetary policies were adopted by Fed chief Ben Bernanke during the period of recovery for the States. Unexpected changes in monetary policy actually have larger impact on inflation at this point in time for the country.
Again if the RBI’s objective is to tame inflation and long time price stability then the government needs to act very carefully. Their elusive want to reduce the fiscal deficit cannot be tamed as the inflation should be the higher priority. It is actually a viscous spiral. If you ask me, I would say fiscal deficit and inflation are actually inversely correlated. Therefore, to have policies to tackle both at the same time would lead to contradictory results. I would back my point of view by this example: If the government wants to reduce the fiscal deficit then they have to either continue with taxes on imports and customs on the commodities. The only way the deficit is going to come down is if the taxes are raised higher and positive revenues are generated. But the problem is by doing so again the prices would eventually be affected as the rise in the taxes will get translated into higher prices in the market for commodities. Another point to back my argument is even if the inflation is being caused due to supply constraints, is it justifiable for the government to burden the producers with further taxation?
Therefore it is not possible for two contradictory policies to coexist simultaneously. The counter argument is in the case of Brazil where at one hand the government development bank is providing huge amount of capital to the sectors and on the other hand raising the rates of lending to tame inflation. But in their case the story is different to certain extent because the private banks there are anyways not willing to take the risk to sponsor long term projects and the government is worried that this will translate into lack of progress of the economy. In our scenario this rule does not apply.
I believe there is a need for further stringent policy adaptation by the RBI to control inflation and thus further rate increases are to come in the near months. If the RBI does not come up with stringent unexpected rises in the repo and reverse repo rates then the inflation is sure to cross double digits within the coming six months.
