Saturday, April 5, 2008

The Battle between Inflation and Growth

Food prices are at an all time high. High enough to take the attention away from the GDP growth story that has been in the limelight for quite some time. The situation seems to be rising to a frenzy panic, as the government changes its tone and changes its priority suddenly away from growth to --what it calls "A more important priority" -- containing the inflation. It appears more like a damage control exercise than a carefully implemented instrument. The sudden state of affairs is more of concern than the absolute value of inflation (reaching an three year high of 7% !) itself.

The grim situation has further compounded with the onset of a untimely monsoon in North India and destroying further crops. With global food reserves running low and a heavy shortfall of supplies for domestic use, the situation could hit the consumer rather seriously. The committee of secretaries on prices is scheduled to meet on April 9th to review the situation. The long term objective will surely be to achieve self sufficiency through increased domestic production (read :Krishna Prashanth: In search of our Daily Bread) With just four days to go before the meeting of the committee of secretaries on prices, it is necessary to analyze the options that we have in hand to stop prices from hitting the roof. After the government has tried its instruments to battle the inflation (like minimum export price on food grains, or total ban altogether) the RBI could be the savior to pull the economy out of this inflation

RBI has mainly three weapons in its arsenal to contain inflation.

a) Increase the CRR /SLR

This mainly constitute of Cash to Reserve Ratio (CRR) and Statutory Liquidity ratio (SLR). CRR is the portion of deposits (as cash) which banks have to keep/maintain with the RBI. This serves two purposes: firstly, it ensures that a portion of bank deposits is totally risk-free and secondly it enables that RBI control liquidity in the system, and thereby, inflation. This is very likely to happen in the current case, especially since this is the most effective inflation control but then again liquidity in RBI coffers means adverse effect on growth! The RBI should play this carefully.

b) Increase the discount rate

This is the rate at which the RBI makes very short term loans to banks. Banks borrow from the RBI to meet any shortfall in their reserves. An increase in the discount rate means the RBI wants to slow the pace of growth to reduce inflation. In our current case this can lead to seriously affecting businesses that depend on short term loans from banks. This can seriously affect the booming market condition.

c) Increase in the Repo rate

It is the rate at which the RBI borrows short term money from the market. After economic reforms RBI started borrowing at market prevailing rates. So it makes more sense to banks to lend money to RBI at competitive rate with no risk at all. A higher repo rate will encourage banks to lend more to the RBI coffers, thus improving the liquidity to contain inflation.

Now these methods are effective, but at the cost of the ever so desired "growth". Its like having to choose between the lesser of the two devils namely "inflation" and "reduced growth". And in situations like the current scenario, makes sense to choose to slacken growth if we can win the battle over the spiraling inflation.

1 comment:

Sita said...

Yes. There has to be a balance between economic growth and inflation. A constant check on inflation is reqd. We cannot give importance to economic growth at the cost of rising prices.

Currently inflation is the problem. People are finding it difficult to manage their budgets with the rise in prices of all essential commodities.

Once this problem is tackled, we can concentrate on economic growth.