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Quantitative easing – Growth vs Inflation

, April 29, 2013, 0 Comments

The reluctance of the RBI to reduce interest rates had primarily been on account of the fact that the government has not moved on the fiscal front to control the level of fiscal deficit and subsidies. Today the ballooning Current Account Deficit has also become an issue. The proponents of quantitative easing are of the view that high interest rates are a stumbling block to accelerating economic growth rates. They are of the view that at the present juncture when economic growth rates have considerably receded the priority should be given to accelerating growth and the objective of controlling inflation should take a back seat.

There is no dispute about the fact that the oil companies are incurring losses selling petroleum products below costs. The dispute is primarily about the fact as to how much of their losses oil companies should be allowed to recover from their sales by increasing prices. Petrol is a deregulated commodity and the question of increasing its price is not a matter of dispute. The real controversy arises over increase in price of diesel, cooking gas and kerosene.

The increase in the price of diesel certainly has an impact on inflation. This commodity is an input in the transport sector (both road transport as well as railways), as well as in the power and agriculture sectors. Increase in price of diesel increases the cost of public transport, cost of power generation and also impose an additional burden on farmers. There is no point in denying this reality. As against this if diesel prices are not increased it will adversely impact the finances of the oil companies and will constrain their ability to invest in new oil exploration and could ultimately result in larger imports of petroleum products and could also lead to shortages in availability of petroleum products in the market.

While increase in price of diesel can lead to cost push inflation, not increasing its price will lead to higher subsidies and fiscal deficit, contributing to demand pull inflation. Economic management involves balancing of various policy outcomes and the same policy can lead to outcomes that are favorable as well as unfavorable. Increase in diesel price will be one such policy decision which can lead to results that are positive as well as negative. The government has now allowed companies to increase the price of diesel by 45 to 50 paise per month.

In several European countries such as Greece, Spain and Cyprus we have seen the impact of following populist policies over a prolonged period of time. India has not reached such a stage because government finances in the country were well under control until a few years back. It is only in the recent past that the situation has really gone out of control. While, as of now, the situation has not yet reached a breaking point, things could deteriorate if the fiscal situation remains adverse over long periods. This is the danger from which we should be on guard.

The primary responsibility of the central bank everywhere is to maintain price stability. In India the RBI has been playing a commendable role in this regard. Its maneuverability to relax monetary policy in the current Indian context is restrained by the prevalence of high inflation and high fiscal and current account deficit.  The central government on its part should play a supportive role by imposing fiscal discipline which has been lacking in the recent past.

Since India is today no longer a closed economy, it is all the more important that we should reign in inflation. High rates of inflation in the Indian economy compared to international rates can lead to depreciation of the rupee in the foreign exchange market. Price stability in the domestic economy is also an essential pre-requisite if India is to successfully move towards convertibility of the rupee. For economic stability in an era of convertibility, there should be a parity in rates of inflation in the domestic economy with the rates prevailing in the leading economies of the world.

With the sharp fall in price of crude oil and gold in recent days the situation as regards current account deficit has eased considerably. Fall in international price of crude oil reduces our oil import bill and the outgo on account of petroleum subsidies thus paving the way for both lower fiscal as well as current account deficit. Similarly reduction in price of gold can reduce the craze of the public for the yellow metal and also reduce import of gold which is again a favourable factor contributing to lower current account deficit.

The rate of inflation is also showing a tendency to decline. With lower rates of inflation and reduced fiscal and current account deficits the stage has been set for further quantitative easing by the RBI. We can look forward to a reduction in policy rates by 25 basis points in the next policy review by the central bank.