Wednesday, March 17, 2010

Inflation and the Prime Minister

So inflation has risen once again and we see all sorts of policy statements in response. Today's news is the PM's statement that interest rate hikes are being considered to combat rising inflation. It's incredibly funny that even an eminent economist such as Dr. Manmohan Singh has fallen prey to the simplistic belief that this will help.

The current spurt in inflation is not entirely unexpected. When fuel prices were increased in the Budget, it was only natural that the WPI would rise. So why the noise? And why ridiculuous statements which imply that somehow, fuel and food prices would miraculously come down if interest rates rise?

Fact remains that government policies are squarely to blame for rising inflation. Primary responsibility for this is borne by our weak currency policy. India's currency market is distorted by RBI intervention. Almost constant buying of USD, which is reflected in everincreasing FX Reserves, leads to an artificially weak currency which is completely at odds with economic reality. Granted that we have a trade deficit, but remittances and other invisibles ensure that we maintain balance in our current account. And in the odd periods that we do have a current account deficit, portfolio flows keep our overall balance strongly in surpus territory. Which is what the RBI buys to prevent the currency from appreciating. And does not allow the nation to benefit from the disinflationary impact of a strong currency.

But why do we need a weak currency? Supposedly, it helps exporters and is therefore, considered beneficial to the economy. This belief has absolutely no fundamental foundation. Please read my multipart post on The purpose of Exports for a detailed analysis.

The prices of Food, Fuel and all other commodities would reduce if the currency were to appreciate, but that of course isn't reason enough to allow it. Not even at a time when, according to Montek Singh Ahluwalia, inflation is in 'worrying' zone. Apparently, it's not worrying enough...

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