Inflation

Inflation in India has been beyond the comfort of the political class and the central bank since 2006. While large proportion of the political class did not care until growth rates continued at high levels and rural transfers kept pace. In the recent years it has become an entrenched problem with no end in sight.

Well, this is how it has worked through in the system:

• If we look back, to 2005-2006 the flow of easy money before the 2008 crises resulted in the country's GDP growth expanding to 8-9% levels. This opened a significant gap between supply capability and demand with prices of industrial products like cement, steel, capital equipment experiencing high price growth;

• Sharp increases in international commodity prices first driven by growth and then post 2008 by low interest environment;

• Food inflation driven by overall change in food habits in emerging markets but especially in India driven by gross mismanagement of the farm economy - persistent hikes in MSP (minimum support prices) and procured quantity without encouragement of any investment in supply chain (reduce wastage), Food Corporation continuing to store grains far in excess of capacity (>3 times capacity) etc;

• This first bout of inflation drove households into real assets like gold and real estate to protect the value of their money. Massive scale corruption further resulted in further increasing real estate prices (largest sector of the economy to hide black money). Higher real estate prices in turn translated into higher prices of delivered goods and services;

• Continued inflation in the last 7-8 years has created very high household inflation expectations (>10%) keeping wage growth at high levels;

• High fiscal deficit and household affinity to gold has created pressure on the currency which in turn makes imported goods more expensive.

During this period urban households have borne the brunt of higher inflation as continued wealth transfers by various social schemes has resulted in higher rural consumption levels and higher rural prices of farm inputs (i.e. labor, land).

While inflation continued, the Reserve Bank post the crises has tried to manage interest rates at relatively benign levels to ensure government debt cost was under control. As it did so, it punished the savers and consequently we have seen a decline in savings rate of the economy from 37% in 2008 to a likely under 30% number this year. This has implications on the long-term investment capability of the economy (domestic + imported savings = investments).

While the government and industry clamor for lower interest rates, they did not want to pay for the excesses i.e. over-leveraging. Significant reliance on global savings to fund this leverage has resulted in the recent currency debacle.

The massive distortions created by the government (i.e. farm and fuel prices) need to be resolved while incentives need to be provided for infrastructure creation. Banking reforms need to be undertaken to allow quick resolutions of bad assets to allow capital assets to be used productively. Reserve Bank needs to correct its policies favoring negative real interest rates. This will ensure long-term stability of the banking system, creating incentives for financial savings as against real assets.

But markets will not wait forever for the government and central bank to manage this, inflation will consequently conquer itself - through demand destruction but albeit over a longer period than would have been through appropriate course correction. Consumer demand and job growth is already impacted in urban India which will percolate to rural economy. For industry, international demand will again become a key driver of growth.

Only one aspects as I see it can result in a different outcome - substantial decline in global energy prices..maybe that is what Reserve Bank and Government have been punting on since 2009? Our old men have over-spent in a casino on a losing trade...