Reddy may be tilting at the windmills

The recent monetary tightening by the central bank may not quite help tame the inflation dragon. An ETIG analysis shows the WPI-based inflation rate is impacted by factors such as the base effect and supply constraints in key products such as foodgrain, cement and steel, rather than money supply and demand factors.

In response to rising prices, RBI has been tightening the monetary screws in the hope of curtailing inflation. This is based on the belief that prices tend to rise as money supply increases, leading to rising demand. However, historical data for money supply (M3) and inflation for the country during April 2002 to March 2005 indicates a negative correlation between the two variables.

The trend does change during 2005-06, with the relationship between increase in money supply and inflation strengthening. While a part of this phenomenon could be attributed to demand factors, increasing supply constraints, especially in key commodities, are largely responsible for spiralling inflation rates this year.

Moreover, primary articles, comprising foodgrains, oilseeds, fruits and vegetables, milk, spices, fibres and minerals, contribute 40% to the current inflation. Thus, the demand for primary articles, which is mainly for essential products, does not change widely with changes in either income or prices. Therefore, demand does not reduce beyond a certain limit even if their prices shoot up.

No wonder then, that the recent hardening of short-term interest rates and CRR rates have not had much impact on headline inflation. However, in the coming months, there could be some moderation in the inflation rate as the base effect begins to kick in coupled with the fresh arrival of rabi crops, primarily wheat, which could ease the pressure on supply. At the same time, there could be some factors that build further inflationary pressures.

These include a tentative rise in the prices of vegetables and fruit due to their seasonal nature, the possibility of low arrivals of wheat because of sudden heavy rains in March, decline in production of edible oils, firming up of tur dal and edible oil prices taking cues from global prices, increasing steel and cement prices and a resurgence in crude oil prices in the international market.

In such a scenario, monetary policy measures aren’t of much use. Rather, current announcements will adversely impact vibrant economic growth by dampening genuine consumption and investment demand. Major sectors such as banking, automobile, construction and as a result cement, FMCG and infrastructure industries will be hit by these measures.

The country’s economic growth is already expected to moderate to 8% in 2007-08, but monetary tightening may further slow down growth.