Editorial, 30-10-2013

RBIs interest rate increases are the best

course monetary policy can follow at this
time
RBI governor Raghuram Rajan's decision to increase policy interest rate by one-fourth of a
percentage point to 7.75%, the second such increase in six weeks, indicates that he believes
pulling back consumer inflation is the most effective way monetary policy can help the
economy regain momentum. It also indicates that he has decided nudging up interest rates
and thereby pulling down aggregate demand for all goods and services in the economy is the
best way to deal with high food prices. In the context of India's recent experience, Rajan has
made the right call.

Elevated food prices in India haven't been about one month of aberrant rainfall. They have
persisted for a few years and consumer inflation measured by CPI-IW has averaged 9.5% for
the last six years. Persistence of high inflation suggests that it isn't merely a supply-side
problem. This is also a problem of the demand side; loose monetary and fiscal policies have
helped push up prices. Even now, food makes up the single largest spend of an average rural
or urban Indian family. High food inflation has second-round effects as it pushes up the
general level of prices on account of a change in people's expectations.

Once expectations of a persistent, sharp increase in food prices are entrenched, it triggers a
rise everywhere. For instance, RBI data shows that private companies over the last 15 months
(till end June), that is five quarters, gradually saw growth in post-tax profit dip and then
contract in relation to the previous year. Simultaneously, staff expenses saw double-digit
growth every quarter, indicating the extent to which second-round effects had set in.

Monetary policy is at best a short-term stabilisation measure. It can't trigger sustainable
economic growth, which requires structural changes to make the economy more productive.
However, if monetary policy ignores inflation in the short run, there will be long-term
consequences. We saw that earlier in the year when events outside India made investors re-
rate the implication of the size and composition of India's current account deficit. The
consequence was a level of volatility that may well have led to many an investment plan
being postponed. Years of high inflation have also pushed household savings towards gold
and punished people holding banks' fixed deposits.

Rajan's effort needs to be complemented by a tighter government fiscal policy to get the most
out of a dose of bitter medicine.