As expected, there was no respite from rate hikes when Reserve Bank of India (RBI) announced the monetary policy on Tuesday (25th Oct, 2011). This was the 13th hike since March 2010. Considering stubborn inflation, RBI had no choice, but to increase the interest rates. After all, the prime objective of RBI is to stabilize inflation within a limit. However, all these efforts have not yet given any positive results so far. On the other hand, they seem to be damaging the growth prospects of the Indian economy.
Earlier our economy was facing inflationary pressure only. But now it is facing a bigger threat. The threat of mild stagflation! In simple terms, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down. This is what we are facing now. In its monetary policy review for second quarter FY12, RBI indicated that the Indian economy is clearly seeing slowing growth. Various factors such as anti-inflationary stance of monetary policy and the significant slowdown in investment activity are curbing the growth momentum of the Indian economy.
Now policy makers are facing a bigger dilemma. If they continue to fight inflation the way they were doing for the last one year, it is bound to damage the investment sentiment as it would make new investments less attractive at higher interest rates. However, if they decide to pause now, inflation may go out of control.
Is there any way forward? For that we need to look into why all efforts put by the apex bank to curb the stubborn inflation have failed. It happened mainly due to two reasons. First, the much-talked-about supply side constraints. And the second, the creation of excessive demand, well supported by different government schemes such as subsidies. Hence, the fiscal policy has been totally out of sync with the main objectives of monetary policy.
Now the time has come for both the Indian government and the monetary policy makers to work together. The government especially needs to refrain from creating excessive demand. Rather, it should work on policies to lessen the supply side constraints in our economic system. But more importantly, the government must put concerted efforts to curb the widening fiscal deficit gap.
Else, sooner or later, we would be facing more heat of stagflation.