Is it really necessary to raise interest rates in India?

As India has seriously entered the global world, the economic debate has also begun to take on an international flavour. There is talk of business cycles, overheating, anchoring of inflationary expectations, etc. A very welcome, and necessary, change from yesteryear when macro policy consisted of just controlling the growth of money supply.

The change in talk has not been accompanied by rigour in analysis. The discussion on an overheating Indian economy is illustrative. To repeat the obvious: overheating implies that economic growth is at unsustainably high levels; if allowed to continue, overheating would have an undesirable impact on inflation.

Hence, it needs to be nipped in its infancy so that inflationary expectations are properly anchored. There are two logical connections here; first, that analysis should establish that the economy is overheating; second, the analysts should establish a reasonable connection between the magnitude of overheating and the magnitude of extra inflation.

When pursuing this exercise, let us all be honest to admit that symmetry has to exist. If this honest exercise leads to a conclusion that the economy is underheating, i.e. growing below potential, then monetary loosening is called for!

Some facts related to overheating (see table). For the 23-year period 1980-2002, the Indian economy grew at an average rate of 5.6 per cent per annum. Post 2002, now for some six years, GDP growth has taken a step jump towards 8.5 per cent. Is this 3 percentage point increase a sign of overheating? Not if accompanied by increased savings and investment; yes, if propelled by unsustainable borrowing.

On this simple rule, there is no evidence of overheating as both saving and investment rates have increased by 10 percentage points each - from an average of 23-24 per cent to an average of 33-34 per cent. Accompanying the surge in growth has been an equally surprising increase in employment growth from 1.8 to 2.8 per cent per annum.

Assuming no increase in productivity growth (an unreasonable but conservative assumption), the increase in growth rates of capital and labour would yield a potential GDP growth rate of an extra 3 percent per annum.

Which means a growth rate of 8.6 per cent per annum - the actual growth rate during the last six years (including an estimate of 8 per cent in 2008-09) was 8.5 per cent!

So no evidence of overheating in the last six years; yet the discussion by policy makers and investment bankers has been consistently that the acceleration in GDP growth has been a consequence of overheating; hence, the need, nay dire necessity, of controlling the side-effects of this heated growth, namely inflation.

The GDP data just released indicate a y-o-y inflation figure (GDP deflator) of 7.6 per cent compared to 6.1 per cent in the same period last year. Is this a sign of overheating or much more a sign of imported inflation?

There is no premium, indeed discount, for not following the crowd. No forecaster, economist, or investment banker ever lost her job because she did not follow the herd.

Even pink newspapers (perhaps especially) are prone to this benign foot-in-mouth disease. Business Standard, in an editorial on Sept. 3, stated: "Once embarked upon [an anti-inflationary policy] such a stance must be followed to its logical conclusion, which means that as long as the inflation rate is above the comfort zone, policy rates must be raised" (emphasis added).

Let us examine the sequence of expert logic: the economy is over-heating, even though there is no evidence of the same (this is not to deny that certain sectors of the economy are overheating while also realising that certain sectors are undercooked).

If the economy is not over-heating, then higher inflation could not have been caused by higher than expected economic growth. We all agree that inflation is high, and most sensible analysts attribute it to the high degree of imported inflation, especially for fuel.

The specious argument is sometimes made that the recent 30 per cent ($40) decline in oil prices will not affect inflation because we did not pass thru the full magnitude of the oil price increase. With each $10 decline in the price of fuel, the fiscal deficit is lessened by 0.5 per cent of GDP. This lessening may not have an impact on inflation, but no one should argue that a decline in the deficit is inflationary.

Some numbers on commodity price inflation are revealing. The average decline from the peak in energy, metals and agriculture has been 25-35 per cent (natural gas is half its value of just two months ago).

With commodity prices declining, either because they were overbought, or because of "demand destruction", it does follow that inflation rates, which were brought up by imported inflation, will, over time, be brought down.

The logic of much that passes for analysis of the Indian situation, by both domestic and foreign analysts, is as follows. Inflation is high because there is overheating. We should therefore continuously increase interest rates until we see an inflation figure that we are comfortable with, say, 5 per cent. [See the quote on the editorial.] This, regardless of the fact that interest rates in India are already the highest in the world.

GDP deflator in the first fiscal quarter averaged 7.6 per cent, the repo rate is at 9 per cent. The real rate: 1.4 per cent. This conclusion about the highest real rates in India follows regardless of the price measure used, as long as different price measures are not used for different economies. It is true this statutory warning is ignored by most analysts!

It is a matter of historical record that the same arguments were made about the Indian economy, and Indian inflation, when commodity prices were on their upward march.

It was Keynes who rather brilliantly said: When the facts change, I change my mind. What do you do, Sir? Obviously, us monetarists and wannabe Indian central bankers don't believe in anything Keynes said!

The author is Chairman, Oxus Investments, a New Delhi based asset management company. The views expressed are personal.