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Economics Of Growth & Inflation

RBI economists say that the Indian economy may see a inflation-induced decline in growth rate

The economic czars of India today have realized that there is indeed a trade-off between growth and inflation. Consequently, they are belatedly trying to curb persistent inflation by jacking up interest rates that would inevitably result in a slowing down of industrial investments as well as loan-driven acquisitions of real estate and cars. Recognition seems to have dawned on some in the capital’s North Block and Yojana Bhavan as well as on Mumbai’s Mint Street that while economic growth is certainly desirable, growth in itself is meaningless unless it is simultaneously accompanied by job-creation.

The recent May 3 decision of the Reserve Bank of India (RBI) to increase repurchase option (repo) and reverse repo rates applicable to transactions in government securities by 0.5 per cent may have sent stock-market indices crashing but the move was along expected lines. (Since March 2010, the RBI has hiked its policy rate by 3.5 per cent to 6.75 per cent on eight separate occasions.) In a hugely under-banked country where a third of its national income is still saved despite niggardly deposit rates, the central bank and apex monetary authority increased the interest rate on deposits in banks’ savings accounts from a niggardly 3.5 per cent to 4 per cent. While the increase in the deposit rate will increase banks’ cost of funds which will be passed on to customers, the fact is that in this country as much as 42 per cent of the savings of rural households and 24 per cent of the savings of urban households are kept at home in the form of cash, according to a study done in 2010 by the National Council of Applied Economic Research.

The RBI has projected the rate of growth of gross domestic product (GDP) for the financial year ending March 31, 2012, to be somewhere between 7.4 per cent and 8.5 per cent, significantly below the 9 per cent (+/- 0.25 per cent) estimate put out by the Ministry of Finance in its Economic Survey presented late February. The RBI has projected the overall rate of growth of bank credit during 2011-12 to be 19 per cent, against a two percentage point higher credit growth during the previous fiscal year clearly indicating an expected deceleration in credit off-take – that is likely to impact the real estate and automobiles sectors the most.

For the first time in recent years, economists at the RBI have not minced their words by arguing that the Indian economy may soon go through a phase of “stagflation”, or a period when a decline in the economic growth rate is accompanied by inflation. With headline inflation at an uncomfortably high 9 per cent, the RBI said “policy interventions are necessary” to control inflation even though risks to growth remain, emphasizing that it is necessary to lower inflation “as quickly and as decisively as possible”.

The central bank’s report has pointed out that inflation would moderate slowly in 2012 but remain above the “comfort level”. “Risk to growth from sustained high inflation could condition the stance of the monetary policy in near term,” the report stated, adding that “since high inflation itself could disrupt growth, it is important for the monetary policy to ensure a low inflation environment as a pre-condition for sustained high growth.”

In 1958, New Zealand born economist William Phillips had argued that historically there is an inverse relationship between the rate of unemployment and the inflation rate. Simply put, what he posited was that the lower the unemployment rate in an economy, the higher the inflation rate, at least in the short run. The RBI is clearly unimpressed by this thesis. “Episodes of high inflation have typically been followed by slowdown in growth rates…Recent evidence suggests that while it may hold for very low levels of inflation…”, it wrote, stating that the so-called Phillips Curve is not relevant for all times as at “high levels of inflation, growth could be lower, coupled with higher unemployment”.

It’s been a while since concern about unemployment has found mention in an official document. That’s good news at a time when news about the economy is not great.