The current economic situation is as follows –
1) Growth is high – at 8-9 % p.a
2) Inflation is even higher – at 11 % p.a
3) Inflation i s high for fuel , a huge importer (despite subsidies) and essential food items (a big importer.
4) Non -food credit growth is high (as per the Central Bank ..the Reserve Bank of India,RBI)
5) There is a general election next year , hence inflation is the top concern
6) Economy is dependent on services , and is sensitive to dollar depreciation. Inflow of investment and export dollars is almost matched by outflow for oil imports (nearly 70 %)
7) Equity markets are in a slump (down 25 % this year)
This has led to the RBI doing the following – clamp down on monetary supply by hiking key rates.
Situation is almost the same as the US except that the US has lower growth , nearly a recession , a distressed credit and mortgage market, and has big war expenditures.
Unfortunately by clamping down on rates ,inflation is less likely to come down because both oil and food expenses are not discretionary expenses.By making capital goods more expensive, the manufacturers will likely pass the increased price to customers leading to demand slowdown first and price slowdown much later if at all. Oil and food will continue to be managed price items hence the subsidy bill on government is going to be higher thus leading to slower investment growth.It might just lead to a mortgage crisis in India as adjustable floating rates are now likely to touch 12 %.
By blindly following Friedman ‘s economic monetary policies of money control, the central banks are ignoring the fundamentals of the current crisis in which essential commodities are having increased prices, and growth is threated by global and financial market failures. Ironically these are conditions that have taken place almost 79 years ago in the macro economic event called Great Depression. A return to Keynesian economics and using the huge bulk up of stored dollars in foreign exchange funds to drive growth rather than shrink money supply should be the way forward. It is necessary to grow out of this crisis rather than shrink and try and dodge it.
This will however require political leadership in driving long term infrastructure programs rather than short term monetary handouts and subsidies.