Heat Is On

Our goal is to pursue growth with monetary stability" is typically a standard line in most official statements on monetary policy. Quite significantly, the growth objective played a noticeably subordinate role in the RBI's annual monetary policy, released by RBI governor Y V Reddy a few days ago. This is consistent with the recent policy measures announced by the central bank. These measures have all been designed to bring inflation under control, even at the cost of a possibly lower rate of growth in the short run. Perhaps, the pursuit of growth is not the main concern of policy-makers today because the Indian economy has been growing remarkably rapidly over a fairly long period of time. More importantly, the economy has been growing pretty much on its own without much assistance from government. During much of this period, growth was accompanied with price stability. However, in recent months, the economy has been exhibiting classic signs of 'overheating' with high growth accompanied by a rate of inflation that has now exceeded 6 per cent. In somewhat simplistic terms, 'overheating' occurs when excess demand in the economy pushes up prices because supply falls short of demand. This phenomenon is most likely to occur when an economy is growing very fast, and that too over a sustained period. A very likely consequence of this sustained high rate of growth is that industries begin to operate at close to full capacity, and so are not able to increase supply in the short run even though they realise that there is sufficient demand in the economy to mop up additional quantities. Even in sectors where industries operate below capacity, infrastructural cons-traints may prevent any expansion of output. Governments and central banks have limited policy options in correcting an overheated economy. Since an excess of demand over supply is the root cause of overheating, corrective measures must either reduce demand or increase supply. But, if it is the absence of adequate capacity that is constraining supply, then there is very little that government can do to increase supply, at least in the short run. In recent months, the surge in food prices accounts for a large component of the overall inflation. Government has adopted some limited steps to augment food supply. The ban on export of food items will have some beneficial impact on domestic food supply, although the quantitative effect may be limited since current wheat exports have not been very high in any case. In addition, only the more expensive varieties of wheat are typically exported, and hence there may not be any increase in domestic supply of the more common varieties of wheat. Government has also taken some direct steps to abate the price rise. Most important of these has been reduction in the prices of petroleum and diesel. Fuel is an important component of the overall price index, and so any reduction in fuel prices has an immediate direct impact on prices. Moreover, any reduction in their prices has an important indirect effect since this reduces transportation costs. This in turn brings down the cost of a wide variety of items of common consumption. The RBI's recent efforts have focused on controlling aggregate demand. And it is here that some fine-tuning becomes necessary. Efforts to reduce the availability of credit are the textbook remedy to curtail aggregate demand. However, a large reduction in credit supply may constrain the expansion plans of entrepreneurs and thereby have a negative effect on the prospects of long-run growth. Increasing globalisation also creates its own problems for monetary policies designed to curb inflation. Indeed, Reddy has identified the surge in net inflows of foreign exchange as the main concern of monetary policy today. We have now accumulated an excessively large stock of foreign exchange reserves. The continuing inflow of foreign exchange essentially means that the world demand for rupees exceeds its supply. If the RBI does not intervene in the foreign exchange market, this excess demand would cause the rupee to appreciate relative to other foreign currencies. Any appreciation in the external value of the rupee makes Indian exports less competitive in foreign markets, and hence reduces exports. As readers probably know, the rupee has appreciated almost 10 per cent against the dollar in recent times. Not surprisingly, the Indian export sector has not been doing too well during this period.