The great Indian inflation debate shows no signs of abating and if the prevailing trends are any indication, it may continue well into the foreseeable future. The RBI recently enacted its 13th continuous repo rate increase in an attempt to bring inflationary pressures under control. But monetary policy may be on its last legs as the negative impact of high interest rates on economic growth already appears to have become predominant.
In the circumstances, it is not surprising that inflation has become a political football. Opposition parties, civil society organizations, and opinion makers in the media cry hoarse at the government's inability to bring down food prices. They blame everything from bad policies to corruption to inefficient bureaucracy to hoarding for the persistence of inflation. Why is the inflation monster becoming so intractable?
Econ 101 teaches us that economies are at their most efficient when they grow at their production possibility frontier, which is a function of the basic resources - manpower, capital, and infrastructure - available in the economy. Any economic growth is under-pinned by these available resources. As economies expand at their natural pace, it accumulates these resources, and a positive virtuous spiral of growth is generated - growth brings in tax revenues, which are funneled into capital investments, which in turn creates the platform for further growth.
However, when the economy experience a sudden growth spurt, wherein the trend rate of growth is suddenly lifted up, the available resources often get depleted quickly and its growth may fail to keep pace with the needs of economic expansion. In simple terms, the economy grows much faster than the supply of resources required to sustain the expansion. More factory capacity is built up than electricity supply can support; manufacturing production exceeds the ability of transportation facilities to move them by road, water and air; cities grow much faster than local governments can provide civic infrastructure facilities and so on. The economy is "over-heating".
Amplifying all this is the impact of growing incomes generated by the booming economy, which changes people's living habits and expenditure patterns. If coincidentally the government is indulging in some direct fiscal spending to boost incomes across the board, then the demand pressures burst open. In such circumstances, where aggregate demand is on the up and the supply infrastructure and other basic resources not keeping pace with the requirements, inflationary pressures are inevitable.
India is experiencing something similar to that described above. A decades long trend annual growth rate of around 5% suddenly gave way to near double-digit rates since the turn of the century. Once the initial slack and spurt of government investments had run its course, the supply constraints started showing up. The supply of capital resources stagnated and failed to keep pace with galloping demand.
Targets in critical infrastructure areas like provision of civic utilities, roads, power generation, port capacity addition, agriculture storage etc were repeatedly missed. A severe shortage of skilled factory and construction manpower and qualified engineering personnel has very badly affected businesses. The high interest rates are only exacerbating this trend by creating constraints on the supply of capital.
The well-intentioned NREGS has had the direct impact of giving thousands of crores of additional cash in the hands of rural poor, besides boosting labour wages across the board. The income effect created by all this has increased disposable incomes and boosted aggregate demand across the economy. The supply-side has badly lagged behind this huge spurt in demand. Inflation was almost inevitable and will persist till these conditions change.
It is clear that while the demand side is robust, the supply side appears constrained. The rise in inflation is therefore more due to cost push factors than demand pull ones. The primary objective in a cost push inflation scenario is to ease supply side bottlenecks. The major domestic supply side bottle necks that have been driving prices up include stagnating agricultural production and over-stretched infrastructure, especially power and transport logistics.
Assuming that the lions share of infrastructure investments should have come from governments, it would be reasonable to expect government investments to have increased atleast as spectacularly as the recent spike in GDP growth rates. However, even as gross fixed capital formation as a share of GDP has increased impressively since about 2003, government consumption as a share of GDP has remained stagnant. This is despite the considerable increases in government consumption by way of petroleum and other subsidies in recent years. It can be safely presumed that government capital investments, especially in infrastructure, lags badly and remains woefully inadequate.
On a historic perspective, India's economy has, atleast since about 2003, reached a new and higher growth phase. However, this (involving the near doubling of the average growth rates from about 5% annually to about 10%) has not been accompanied by any commensurate increase in government consumption (the spurt in 2008 can be attributed to the different kinds of stimulus spending).
The choices facing the Indian economy are stark. If it has to rein in inflation in the foreseeable future, capital investments in physical infrastructure and human resources will have to increase exponentially. Or else, faced with chronic supply constraints, inflation will persist, and ultimately growth itself will get compressed. Either are not easily resolved and will take considerable time.
The most plausible scenario appears to be a slip back into an intermediate trend growth trajectory, where moderation of growth stabilizes inflationary pressures. Hopefully, this time, the government gets its act together and channels massive investments into basic physical and human infrastructure, so as to set the stage for recovering back into the current high trend growth stage quickly.
PS: Once the over-heating economy line of reasoning is accepted, the central bank faces no trade-off between inflation targeting and economic growth. The objective then is to do monetary tightening so as to cool down economic growth to a level where the supply-side growth is in sync with the aggregate demand growth. The danger of course is that no-one knows how much tightening or cooling is optimal!
Update 1 (4/7/2011)
Evidence of overheating economy comes from this graphical survey by The Economist. Using inflation, current GDP and employment growth rates over the average of the past decade, credit growth rate, and current account deficits, it finds that India is among those handful of emerging economies which are clearly overheating.