Will Rate Rises Fix Inflation? - The Daily Reckoning
The Daily Reckoning by Bill Bonner
On This Day - 17 September 2011
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- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
On Friday, in a widely anticipated move, the Reserve Bank of India (RBI) raised interest rates by a further 25 basis points, in a bid to dampen rising inflation. The RBI has raised interest rates 11 times in the last 18 months, yet inflation remains stubbornly high. The latest figures indicate inflation currently at 9.8%, its highest level in 13 months.

So what is going on here? Despite continually rising interest rates, inflation is rising and now close to breaching the 10% level. Why haven't interest rate increases had the desired effect of bringing down inflation? Let's start by discussing some common factors that cause inflation, and see if this applies to the Indian case.

One factor is global commodity prices. In particular, the price of oil has a significant impact on inflation for nearly all countries. India is an importer of crude oil, so factors affecting the international oil market that are largely outside of India's control, can contribute to inflation.

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In rupee terms, crude oil prices are up just over 4% since the start of 2011. This is a small increase that is much less than the current inflation rate. Thus, crude oil and commodity prices have not been a driving factor of Indian inflation. This can be confirmed by the fact that other large countries dependent on crude oil imports have not seen increases in inflation.

If external factors were the cause of India's inflation, the inflation rates for other large economies would also be as high. However, no other major economy has inflation rates anywhere near 10%. The US inflation rate is 4%, the Eurozone inflation rate is 3%, China's inflation rate is 6%, and Brazil's inflation rate is 7%. We should thus look to domestic factors that may be causing the high and rising inflation rate.

One of the main drivers of domestic inflation has been the price of food. Food price inflation is generally higher than the overall inflation rate, and has been above 10% during the year. Food prices are significantly affected by the weather, and thus out of our control. Poor rainfall and subsequent poor harvests in certain areas have contributed to inflation.

The additional factor affecting food prices is corruption in the markets. For example, towards the end of last year, onion prices rose an extraordinary 350% over a three-week period. It is almost certain that market irregularities and corruption played a role in this, and it is likely that poor governance continues to affect food prices, and contribute to inflation.

The next factor affecting inflation is fiscal policy. In the previous fiscal year, the budget deficit stood at just over 5%. While the RBI has been fighting inflation in the last year and a half, the fiscal side of the government has done little in this regard. Continuous overspending creates additional cash in the economic system, and thus fuels inflation.

Corruption and special interests within politics also play a role. Many economic reforms have not taken place, and the government has been largely quiet on the economic front, while inflation rises and growth slows. This is a long-term problem and can threaten to keep inflation continually too high.

We've identified the major factors driving inflation. These are unpredictable food production, over-expansive fiscal policy, and poor governance (i.e. corruption). This provides us with a good clue as to why the RBI's interest rate increases are not having the desired impact of reducing inflation.

When interest rates go up, the intended consequence is that borrowing is discouraged, and excess cash in the financial system is removed. As a result, investment falls and economic growth suffers. Inflation is also supposed to fall too. Unfortunately, while investment and economic growth have fallen, inflation has not.

For inflation to be brought down, it needs to be tackled from all directions. Interest rates are only part of the story. This includes making food prices less dependent on the weather, through better production methods and management. On the fiscal side, the government should commit to pursuing policies that will reduce inflation. And finally, governance is a factor affecting all parts of the economy, and improvements are always helpful.

Interest rate hikes do not tackle the root cause of inflation, so it is no surprise that it has not been effective in bringing down inflation rates.In fact, due to falling growth as a result of higher interest rates, we are actually seeing some stagflation in the economy. Stagflation is the combination of falling growth and rising inflation.

There is no doubt that we can expect the RBI to continue its fight against inflation. However, to be truly successful in bring inflation down to more acceptable levels, the rest of the government must play its part.

is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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12 Responses to "Will Rate Rises Fix Inflation?"

Rajiv Phadke

Sep 19, 2011

with due respect to the columnist, I dont think that anyone really understands why Inflation occurs and even less - how it can be contained ! All factors discussed in the article are relevant but a correct diagnosis & cure are eluding us. PM himself seems to have given up on this challenge nor does he show enough leadership drive in last 6 odd months. It is only to be hoped that this will change soon....

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Vishal

Sep 17, 2011

Asad,

I like your articles. Interestingly, you answer the questions which are lingering in my mind but dont get answer.
Thanks
Vish

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nvvsmani

Sep 17, 2011

This inflation is due to supply side problem and unproductive govt expenditure. we have imported Keynsian solution of digging trench and filling it up under MNREGA and on unnecessary extravaganza like CWG. The govt blithely says this will go away and expecct RBI action(demand curbing)to work for them. If on one side the govt pumps borrowed money for non productive expenditure and on another side rests on RBI action to partly singe the money,nothing much really gets done and inflation is spiralling without control. The govt itself under pretext of global meltdown violated FRBM Act and the general public is paying the bitter price. Fiscal action is the need of hour and any amount of tinkering with interest rates is not going to help. The tragedy is that the govt honchos are aware of it but will not do anything against the wishes of the first family even if the people who elected them suffer

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Onkarnath Adiga

Sep 17, 2011

Is Government's NREGA Policy one of the contributing factor for India's uncontrolled inflation?

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Anuranjan Gupta

Sep 17, 2011

I am thankful to equitymaster as well as Mr. Asad Dossani for the articles which are explained in such a simple manner that a layman can also understand how economics works in day to day life.I request more articles and opinion from Mr. Asad Dossani.Please keep it up.He can also write more on how to play derivatives so as to overcome fear of losing money playing derivatives.

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ashim

Sep 17, 2011

Nothing may be expected to be done by the agricultural minister as regards better control of food prices. The whooping rise of prices in onions (350%) last year is a pointer to the "efficiency" of this department and its earnestness in developing exports at the expense of the hapless Indian !

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jagdish sanghvi

Sep 17, 2011

Dear Mr Dossani
Your article is intersting as well as engaging. Not being a student of economics, so far I believed the GOI stories that India's inflation is imported and not indigenous. Now, you have given an intersting twist to the whole problem. I would like to believe you than the GOI, as you seem to make more sense. This raises a very dreadful question, which is;

If RBI's efforts of rate increasing will have only a marginal effect, as we have seen so far, and if our politicians (Government) do not improve on other aspects(as we have seen so far), then do you mean inflation in India will never come down??
What will it mean to the growth of India, and India's equity markets?? What will happen to the standard slogan of all analysts "India's growth story is intact"???
I would appreciate your reply for the benefit of all who read this column
Thanks--Jagdish

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Sthithapragnja

Sep 17, 2011

Eq.Master Team,
Inresponse to the question " Will rate rises Fix Inflation??",in all humility I may observe as under:

The presewnt scenario(economic front)prompts me to cite the instance of an Emperor in hiostory who thought himself to be all powerful.

One day heordered that his throne to be carried near the sea shore. Thereafter he seated himself thereon.
In view of those who had assembled there,he loudly ordered the waves of the sea to stop rolling in. But alas the waves continued their movement.

Our government's efforts are also in similar vein
to controlö the price rise,inflation and so on ??
I hasaten to conclude with the admission that I am not an economist !!

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K Vasudevan

Sep 17, 2011

Sir,
There is another major factor in food inflation, It is
the Govts NAREGA programme over the past couple of
years, More than 30,000-40,000 crores of rupees each
year is being freely distributed amoungst the poorest of
the poor,even presuming 50 % really reaches them, for a
person on the brink of starvation or one who makes do
with only one meal a day, any additional money received
first goes towards his/familys food needs. With no
additional efforts to increase the supply side,there is
a mismatch leading to inflationary pressure mainly on
cereals, vegetables,cooking oils, etc.Though it is good
sign that the havenots are eating better,no amount of
increase in the CRR,SLR or Repo rates by the RBI is
going to have any effect on this front except supply
side increase. On the contrary the rate hikes are only
leading to higher prices in the manufacturing,
automobile and housing sectors leading to direct
inflation.It is the same chicken and the egg story,
unless interest rates are brought down in india
inflation cannot be brought down as demand cannot be
controlled by interest factor alone with an evergrowing
working class.
regards
vasudevan

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SADASHIV REGE

Sep 17, 2011

The soon coming elections in many states provide a great opportunity for politicians to hoard black money from their agents contributing to food inflation. In addition, poor storage facilities for storing grains and vegetables which are consumed by rodents and pests are a deliberate strategy to raise their prices, practised by agents affiliated to these state level politicians over the years.

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