Inflation is not only a key leading indicator of an economy that gives headwind direction to the anticipated pace of economic activity but also a factor that is capable of bringing down a government if not managed effectively.

There have been various instances where the government has to face the brunt of sudden price hikes, with the opposition waging a nation-wide protest against them. But is inflation a single factor that behaves on its own, thereby, imparting a cascading effect on the economy, or is it a factor that first gets influenced due to fundamental changes in country-specific and global structures – is a question that needs to be understood and answered. The behavioural aspect of other parameters that significantly displaces the inflation level is the folklore to be understood in order to nip the problems in the bud. Understanding and attacking these structural problems would ensure controlled inflation, resulting into favorable interest rates regime that will harbour economic growth. Therefore, drawing the relationship between corruption, inflation and interest rates is imperative for the policy makers to take appropriate measures and decisions that will lead to economic advancements.

Having set the tone of underlying the importance of finding the nexus between corruption, inflation and interest rates, I am intrigued to ask the most relevant question that has always had a huge impact on economic activities…

…Does Hike in Interest Rate Always an Answer to Contain Inflation?

As far as Indian Economy is concerned, the change in interest rates has always been linked to inflation. This, according to economic theories, is absolutely correct i.e., interest rates should be linked to inflation. Therefore, if the inflation goes up above the controlled levels, the central bank should hike the benchmark rates to cool it down. Then why am I asking this question, is something one would ponder. Excavating the realities that lie concealed in this question would bring out the truth if interest rates should be the only solution to control inflation.

Understanding Inflation

The basic definition of inflation, as we all know, is too many monies chasing too little goods. This means the liquidity available to buy goods and services is in excess leading to a hike in demand for such goods and services. This, in turn, leads to price hikes in such goods and articles – resulting in higher inflation. Therefore, the central bank, in order to control the inflation, would try to restrict the excess liquidity available in the market by raising the benchmark interest rates. But is inflation stemming out only because of this theory – is it that generic; or is there something more to it that brings in uncontrolled inflation. The central bank’s monetary policy in the past has adopted a harsher stance toward interest rates on the ground of high inflation, which, I believe has done more damage than good. In the pursuit of containing inflation, more often than not, the resultant impact on business activities has been ignored. Therefore, what should be benchmarked for adopting favorable policies to ensure sustainable economic progress – core inflation or overall inflation – is something I will talk later in this article.

By now, I believe, the first level of excavation has happened in the pursuit of bringing out the concealed truth. As I go ahead to dissect the Nexus, it’s time to establish the link between corruption and – something that I term as – the Bubbled Inflation.

Corruption and the Bubbled Inflation

This is a terminology that I usually use to signify the degree of uncontrolled inflation emanating from corruption – the Bubbled Inflation.

The technical and the most acceptable definition of corruption is black money. But I would rather say that corruption is the availability of easy money. The fact that it’s easy money, distorts the demand fundamentals in a very abrupt way, thereby creating bubbles in an economy. These bubbles are asset class bubbles (including bullion), commodity bubbles, and bubbles in few pockets of goods and services such as consumer durables & non-durables, passenger vehicles, private healthcare, private education, entertainment, and travel & hospitality, among others. The bubbles across these categories are due to artificial demand stemming from easy money and not because of the fundamental factors of overall growth in demand. Since this is a bubble, the price inflation is not sustainable because of the larger mass – having legitimate money – will find it unaffordable. Therefore, the bubble will eventually burst because the fundamental demand drivers will not be able to provide any support to the prices. As the prices across categories begin to crash, it will significantly impact the economic and investor sentiments leading to slowing down of economic activities, thereby sending the economy into a tailspin. The businesses that would have made gains during the bubble regime, would, in all probability, be trapped since these businesses would have ideally made huge investments in terms of manpower, physical assets, distribution, etc. with the hope to continue to reap benefits. With a crash in prices, the sustainability of these businesses would be at stake, and that would have a cascading impact across the various spectrum of the economy.

Therefore, if the increase in benchmark rates is a reaction to high inflation because of easy money and not concrete demand, it will do more damage than good since the real demand will be dampened further. I believe that, by now, some of the truths have already been unearthed regarding hiking interest rates to contain inflation.

Importance of Core Inflation – Understanding Demand-led and Cost-push Inflation

To decide on the direction of the benchmark rates, it is extremely necessary to understand the difference between core inflation and overall inflation. The basic difference between the two is that core inflation does not include energy (crude oil) and food prices because they are not only volatile but also beyond a country’s reasonable control, which is dependent on oil and food supplies. Therefore, let’s take a look at both the cost-push inflation factors:

1. Energy prices (crude oil) are dependent on global factors impacting the crude oil prices. India, in this case, is heavily dependent on oil imports, and, therefore, any unfavorable movement in crude oil prices will have negative cascading effects on the entire value chain of goods and services since their cost of operations would increase for reasons beyond anybody’s control. Since this cost has to be recovered to maintain sustainability, it is usually passed on to the consumers in the form of price hike or inflation; and this inflation is not emanating from growth in demand but through cost-push factors
2. Food prices are dependent more on supply factors than demand. Even though India’s agriculture accounts for ~15% of the GDP, it’s primarily an agrarian economy, and, therefore, crop production becomes extremely important to secure food supplies for domestic consumption. Given the fact that the penetration of irrigation, especially micro-irrigation, is abysmally low at 11% of the cultivated land, it makes India’s agriculture heavily rain dependent. Therefore, if the crop production is less than optimum, or if it’s spoiled due to extremely heavy rains or lack of storage infrastructure, it will lead to significant supply constraint. This will lead to skyrocketing of food prices, thereby increasing the overall inflation. This increase in inflation, again, is not because of rising in demand but due to cost-push factors

Therefore, in the case of either or both the above situations, if the central bank steps in to contain inflation by increasing the benchmark rates, it will only hurt the economy. Add to this if the core inflation is at a controlled or subdued level, such a stance toward interest rates will hurt the economy even more. Such a rate hike decision reacting to the energy and food inflation will:

1. not be able to bring down the energy and food inflation because the former is governed by global factors, and the latter is always a result of supply constraint
2. further, dampen the demand for manufacturing and services as reflected in core inflation, and will negatively impact the economic growth
3. result in stagflation because of the above two pointers – inflation still remains high due to food inflation, and the overall economic growth slows down

 Rationale for Benchmarking Core Inflation for Movement in Interest Rates

The core inflation is a reflection of manufacturing and services activities responding to the fundamental demand drivers for such goods and services. The movement in the prices, in this case, is demand-led. Therefore, if the core inflation soars higher than the controlled level, a call for a rate hike is justified. However, if the core inflation is subdued, and the overall inflation soars due to energy and food inflation, the policy makers should work toward improving the supply factors rather than raising the benchmark interest rates. This is because if the benchmark rates are increased even if the core inflation is at controlled/subdued level, the borrowing costs for the corporate – manufacturers and service providers – would go up. This would have two immediate impacts – first, the bottom line will get negatively impacted due to increase in borrowing cost, thereby slowing profit growth; and, second, if businesses have planned expansions, such increase in borrowing costs would lead to these businesses deferring their expansion plans until the borrowing costs come down. This will lead to a negative double-whammy impact of the decline in profits and slowing down business activities – thereby leading to slowing down business and economic growth.

Hence, I believe, the realities unearthed all this while highlights one significant takeaway – raising benchmark interest rates is not the only solution to control inflation.

So What are the Ways to Control Cost-push Inflation Factors?

If raising interest rates is not the solution to control cost-push inflation factors, a question might arise that how such cost-push factors be controlled. While I agree that oil prices cannot be controlled since India is not an oil producing nation, but food prices can be controlled by improving the supply dynamics. Some of the ways to improve the yield and realization for agricultural produce are as follows:

1. From rain dependent to self-dependent: With low level of irrigations, India’s agriculture is heavily rain dependent. The financial markets always react to the Met department’s forecast of a good, normal or deficient monsoon. The forecast is the first indication of what the food prices are likely to be and its impact – direct and indirect – on the industries. Therefore, if there is a rapid penetration of irrigations, it will make the farm produce less rain dependent and more productive on crop yields. This, in turn, will help in addressing the problem of supply constraints, thereby controlling the food inflation.

2. Revamping the supply chain structure for higher realization of farmers: The operators in the distribution chain of farm produce until the retailers are many, which results in price build-up at each stage of the chain. This is another variable that impacts food prices and the resultant inflation. When prices of food skyrockets for reasons already mentioned above in the article, it’s the traders who pocket in the windfall gain from such high prices, whereas the poor farmers continue to get paid at MSP fixed by the government. Not a single penny of this windfall gain reaches to the farmers as a benefit. Thus, if the supply chain is revamped where the farmers get a direct access to the retailers, not only will it improve the realization and profits for the farmers but also the food prices will be quite low due to the elimination of the entire profit chain

The above two-pronged strategy of improving yield and profit for farmers will go a long way in keeping the food inflation under control. Therefore, rather than waiving off agricultural loans, if the government invests in improving the productivity and higher prices for farmers, it will be a permanent solution for the farm sector, putting an end to the farmers’ suicide.

The Takeaways

The nexus of corruption, inflation and interest rates is very important that also underlines the fact that “inflation” is not just one-word but a lot to be read and unearth before taking any step toward interest rate movement. While I have a lot of respect for central bank’s understanding and approach toward inflation and interest rates, the tough stand adopted by its governors in the past leading to a hardening of interest rates on cost-push inflation factors could otherwise have been avoided. The economy would be considered red-hot only if the surge in prices is demand-led and not due to bubbles or cost-escalations, thereby calling for actions to cool it down.