Inflation surge spells ever dearer money

MUMBAI: With the tiger’s tail on fire, alarm bells are ringing all over. On Friday, when the weekly inflation numbers registered a higher-than-expected rise to 6.46% (against the expected 6.3%), finance minister P Chidambaram immediately went on record to say that the brakes would be applied harder now.

``The government has taken, and will take, fiscal, monetary and supply-side measures to moderate inflation,’’ Chidambaram said. ``Inflation will ease over the next weeks and months,’’ he said, predicting that average inflation in the year ending March 31 would be 5.4%.

However, industry observers and economists are worried that any further monetary tightening by the Reserve Bank of India (RBI) by impounding liquidity or by raising interest rates will end up hurting growth. The RBI has raised its key overnight lending rate five times in the past year to contain inflation. It has also impounded more bank funds by raising banks’ cash reserve ratio to 6% from 5.5% last month. 

Inflation in the week ended March 3 rose to 6.46% from 6.10% in the previous week due to a faster increase in the prices of cement and fruits and vegetables. The rise in cement prices, in particular, is - ironically - a direct result of the policy effort to reduce its prices.

Prices of cement rose by 4.4% during the week, reflecting the hike by cement manufacturers just the budget raised excise on cement, while fruit and vegetable prices rose by 1.9%. The higher inflation numbers support the RBI’s monetary tightening stance, leading to fears among companies that interest rates could now rise further, stifling growth.

Some analysts say that rate hikes are not the right way to go about tackling inflation. It might - like the cement excise case - actually stoke inflation by raising the cost of borrowing for the manufacturing sector, which will then be passed on to  customers.

“The supply side problems, which are the main reasons for inflation, are not being addressed and rate hikes by the RBI are adding to inflation because companies are passing on higher costs to consumers,” says Ravindra Purohit, economic adviser, Hindustan Construction Company. Small and medium companies are feeling the pinch as larger ones have the option to borrow cheaper from abroad.

Purohit’s views are shared by Prabal Banerjee, CFO of the Hinduja group. “Interest rate hikes have only added to costs. Also, this time, despite the cut in petrol prices, inflation has not come down, which is a worry. Excess money with people is also adding to the problem,” Banerjee said.

Banerjee fears that more monetary actions by the RBI may impact growth and suggests that the RBI should instead direct banks to be more discreet in lending.

Some economists say that interest rate hikes have also not hit government since it is the biggest borrower. The 10-year government bond yield rose above 8% on Friday, soon after the inflation numbers were out.

“Till such time that new (manufacturing) capacities are fully operational, supply constraints will continue to exert pressures on manufactured product prices,” says Shubhada Rao, chief economist, Yes Bank.

However, other economists expect inflation to come down by the end of March and April due to increased supply of primary articles after the rabi crop is harvested.

“I expect inflation to come down to 5-5.75% in the last week of March mainly because of the base effect,” Rao adds. This is because inflation in the corresponding period of 2006 was high, making the current increase seem lower in comparison.

Though the consensus expectations are that the RBI will hike rates at its monetary policy review next month, some economists expect status quo if inflation drops below 6% by March-end.

“The effect of monetary actions come with a large and variable time lag. I think that the RBI may take stock this time, given that they have been extremely aggressive in hiking rates recently,” says an analyst with a US bank.