In the recent days, there have been ample signs that the Indian economy has entered a phase where its economic growth has begun to show signs of a slowdown. GDP growth estimates from various quarters have entered the zone of 7-7.5 percent from the highs of 8-8.5 percent in the last 3-4 years. The Index of Industrial Production has been showing signs of slowdown in the industrial output. Now why has this been happening? The government is blaming the global debt crisis, particularly in Europe for various ills that the Indian economy is facing. While global factors cannot be ignored in the analysis of this slowdown, a closer look will reveal that much of our problems are self-inflicted.
Indian economy has been facing one major problem that has become a major pain for the Indian consumer and has now become a major headache for the government as well. That problem is of inflation. The prices of all major commodities, especially necessities have been steadily rising from the last two years and are showing no signs of a decline. The food inflation has entered double digits and touched the peaks of 13% in November. The reason for such price rise still remains a mystery. The government thinks that this inflation is demand-driven. This means that people are demanding too many goods and services, therefore their prices are rising. In economic theory, when the demand of goods goes high, supply remaining the same, the prices of goods go up. So according to the experts in the government, incomes of people are increasing all across, especially in the rural regions, given the employment generation schemes like NREGA, which is making them demand more higher quality food, especially the protein-rich variety, and this boost in demand is increasing the prices of commodities especially food items.
Now given this logic, the government has chosen the appropriate textbook remedy of demand-driven inflation: raising interest rates. The logic is simple: Rate of interest is a price of holding money. If I take a loan from bank, I will have to pay a rate of interest for the period for which I am taking money, so that’s my cost of holding money. Since the government thinks that it is this too much money in my hands that is making me demand more and driving the prices up, it increases my cost of holding this money which is interest rates. So given my increased cost of holding money, I will reduce my demand for money, which will reduce my demand for goods and services, and will ultimately reduce the prices of goods and services in the economy. So here’s the bitter medicine for inflation. Question is: Has it worked? The answer is: No, and worse, it has had its side effects. Let us see what we are talking about. The economy has two major players apart from the government: consumer and producer. Let us analyse the situation from their point of view one by one.
The consumer
Now, in the beginning of this story, the consumer is already facing high food prices. He hopes that they will come down as it is putting increasing pressure on his wallet as has to keep on increasing his spending on food items, as their consumption cannot be decreased. And he hopes that the government will do something about it. So what the does the government do? It raises interest rates. Wait, why? Oh, that’s because the government thinks that you have too much cash in your wallet and that is raising the prices up. But wait, what is the impact? The consumer gets a call from his bank that his EMI payment will increase on the floating interest rate home loan he has taken. Also, the EMI that he had set aside for the car he plans to buy for his new year is going to be higher than he had planned. There is more, he has to wait till he buys the LCD TV on EMI because now the increased EMI would not fit in his budget.
It does not stop there. The petrol prices go up. Why? Because the government no longer controls the prices of petrol. And why are they going up? Because the oil companies are facing huge losses and the government cannot fund them anymore. So now, the hapless consumer has to shell out more for those litres of petrol that he cannot reduce consuming.
So what has happened with our aam aadmi. For him, the food prices were already up. The fuel goes higher and higher. And the so called remedy of increasing interest rate has increased his EMIs as well. So his wallet has been attacked from all corners: Food budget, Fuel Budget and EMIs. Not good news.
The producer
Let us consider a case of a manufacturer. Rising inflation has been hurting him because the consumer has reduced his demand for goods and services because he is busy managing the budget for necessary items like food and fuel! Inflation is directly affecting him because the prices of raw materials is rising and adding to his cost. On the top of that, he imports his raw material from abroad and the weakening rupee is adding more to his cost because he has to pay more in rupee terms for his import. He looks to government for support to reduce the inflation, which is his cause of worry from both demand and supply side. What does the government do? Raise interest rates. So now the producer gets a call from his bank that the term loan he was planning to take for expanding his plant and the working capital loan he had applied for to keep running his business smoothly will now cost more.
So what has happened to the producer? He was already suffering from decreasing demand on the consumer’s front and increasing cost on the raw material front which was squeezing his profits and now the cost of funds that he desperately needs to run his business has also gone up. So his profits will take more beating. He cannot pass on this increased cost to the consumer because the consumer, who is already reeling under rising cost of food and fuel, will certainly reduce his demand for his product. Not good news as well.
The Diagnosis
There are two problems with government’s remedy here: the logic of that remedy and its effects.
Coming to the logic first, to begin with, if this inflation was demand driven, two years of sustained rise in interest rates would have some effect in terms of reducing it. Secondly, the spikes in the prices of food items like milk and vegetables in the retail market have been too drastic and sudden to be explained by increase in demand. It is foolish to suggest, that suddenly people have started demanding more food. Thirdly, the divergence between the wholesale price and retail price of vegetables are pointing towards a problem in the supply chain, demand has nothing to do with it. Indeed, the irony is that given all the amount of increase in food prices, the producer of food, the farmer is not getting any richer. So the demand logic does not really hold its ground. All the evidences point towards the inflation problem being a supply side problem.

Now, coming to the effect, raising interest rates has led to increase in the problems of both the consumer and producer, as we have seen above. It has done no good to the economic system of India, indeed, it has only harmed it. We have to remember the fact that the key player in the economic growth of India in the last two decades has been the Great Indian Consumer. In a blog article written in May 2011, I had warned that the government policies are playing havoc with the consumer and it is likely to impact the economy in a big way, and I have been proved correct. If we leave the consumer with too little money to demand goods and services, apart from basic necessities, it is not going to be good for anybody. On the top of that, if there is more price rise on account of increased production cost as a result of hike in interest rates, the consumer will demand even lesser. The structure of our economy is so consumption-driven that we cannot afford to have the consumer demand going down. Blaming him for the rise in price and punishing him even more is not going to lend any support to him for him to increase his demand for the goods being produced, which will ultimately only drive the economy down. What needs to be done is to look at the real issues: why are food prices showing sudden spikes? What is wrong with the supply chain? What role are the middle men in food supply chain playing in increasing the price from the wholesale market to the retail market? Why, despite, adequate production, we are still witnessing rise in food prices? Is there a way to improve the agricultural marketing system for the farmers? Can we make a mechanism where the farm output can be directly procured from the farmer, give him a fair price and reduce the role of middlemen in the supply chain? Can we have a second look at our tax structure in fuel sector to reduce the burden on common man? Can we cut wasteful expenditures and projects like Air India and instead spend that money elsewhere like Oil companies?
These are some hard questions that need to be answered if we are really serious about reducing inflation. Otherwise, we will keep announcing that rising interest rates are going to tame inflation in the coming quarter!

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