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Posted by: Uma Shashikant on Mon, Aug 2nd, 2010

Inflation - Answers Still are on the Supply Side

A late evening flight from any city to Mumbai provides ample thinking time. Laptops have to be turned off for landing and about an hour of hovering above the city is to be expected. Perhaps there are clues to the inflation number in this mess, I thought.  The passenger rush has increased significantly and airports are like yesteryear state bus-stands, despite the expansions. Airlines announce new flights and destinations everyday as there is an increase in demand. But they are unable to convert the increased demand to increased profits, since they lose money in costs of providing the services, including the fuel wasted hovering over major cities. The constraint is in the infrastructure, but the solutions target the players.The logical option in such an industry would be to hike prices given the growth in demand. That option may be a tough one to exercise, given competition in the industry, but for the sake of argument, let’s assume that they decide to increase prices. Someone viewing the industry trends comes up with this explanation - prices are sky-rocketing making it tough for the common man to fly. Since prices have gone up, we should increase the interest rates. The fact that passenger traffic is growing so rapidly means there is overheating in the sector, and adequate headspace to bear a higher interest cost. So interest rates are moved up to ‘contain inflation’. This is expected to compel the airlines to bring prices down. That would effectively put a brake on growth in the sector, since they have no capability to expand, given lower prices and unaltered higher costs. If they reduced prices, demand may sustain, but at even higher costs to the airlines, that they would suffer low growth.  

 

The airline story has a simple moral. A growing economy like India is constrained by capacity issues and is unable to meet the demand for goods and services of its economically better-off population. We may cry hoarse about demand-side pressures and need to tighten interest rates. But the net effect of a swift rate cut would be on slowing the GDP growth rate down, than on tempering the prices as expected. Initiatives to enhance production capacity take a long time to show results, but may be the only way for us to achieve long-term stability in price levels. Until then, it may be easier to tighten interest rates and expect inflation to respond. The increase in interest rates may elicit an immediate response from the growth numbers that will inevitable slow down than any secular control in inflation numbers.  

Uma Shashikant on Mon, Aug 9th, 2010 12:29:16 am

Yes, Venky, you are right. The RBI did not have much of a choice and there is always the "demand-side" impact that creeps in, as RBI have themselves noted in the policy documents. Also, a higher interest rate would deter hoarding elements and perhaps set better inflation expectations. Ah, how sorely I miss your keen Editor's eye - error it is indeed - rate hike and not rate cut. Thanks, Venky.

Venky on Mon, Aug 2nd, 2010 8:32:34 pm

Interesting perspective. But let me, with your permission, take the argument one step forward... Even if the RBI is convinced that it's supply-side constraints that are driving inflation, can it afford not to raise interest rates in the short term? Could it not be faulted for inaction, then? The problem, as I see it, is that it isn't within the RBI's purview to address supply-side constraints. And it has only one policy tool to address inflation - even if it is convinced about the nature of the underlying problem. Correct me if I'm wrong... - Also, I think there's a minor mistake in the last paragraph: Where you say: "But the net effect of a swift rate cut.." I think it should read: "But the net effect of a swift rate HIKE..."

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