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The problem, however, comes when inflation isn’t demand-led. Data from the Centre for Monitoring Indian Economy shows the unemployment rate in March at 7.6 per cent. Slaying the inflation monster is relatively easy when the underlying causes have primarily to do with demand. If an economy grows too fast on the back of rising aggregate demand, firms tend to initially respond by employing more workers, pushing up wages and costs of other inputs. As capacity utilisation rises to levels reducing the amount of unused productive resources, firms will next start increasing prices. The standard tool of central banks to address “demand-pull” inflation has been to raise interest rates. By making it costlier for firms and households to borrow, demand for investment and consumption goods along with workers comes down, thereby cooling an overheated economy.
The problem, however, comes when inflation isn’t demand-led. Data from the Centre for Monitoring Indian Economy shows the unemployment rate in March at 7.6 per cent. That’s rather high, given a simultaneous fall in the labour participation rate (LPR) to 39.5 per cent. If even a shrunken labour force is struggling to find employment, it’s hardly indicative of a tightening job market. The RBI’s latest survey of the manufacturing sector shows the overall capacity utilisation by reporting companies at 72.4 per cent for October-December. Although the highest in 10 quarters, it is below the long-term average of 75 per cent from 2008-09 to 2018-19. If anything, it points to recovery from a deep slowdown that began in 2019-20. And the recovery isn’t strong enough to induce overheating — unlike in the US, which had a 3.6 per cent unemployment rate on an LPR of 62.4 per cent in March. Also, the fact that annual wholesale inflation in March, at 14.55 per cent, was more than double the 6.95 per cent rate at retail level suggests limited pricing power with firms: Current demand conditions aren’t allowing them to fully pass on the higher costs at producer level to consumers.
What most countries, including India, are experiencing today is “supply-shock” inflation. There have been too many supply chain disruptions over the last two years, caused first by the Covid-triggered lockdowns and now the Russia-Ukraine war. Coming one after another, they have proved to be persistent than transitory, resulting in what economists term as a leftward shift in the aggregate supply curve and driving up prices for the same or even lower levels of demand. Those critical of the RBI, for being “behind the curve”, should know there’s little that central banks can do about inflation caused by supply-side factors. If interest rates are a cost themselves, wouldn’t hiking risk worsen inflation by impeding supply? And how does cooling something that isn’t hot help really? Policymakers can, perhaps, draw more lessons from the stagflation decade of the 1970s. Then too, it was supply shocks from geopolitics that defied simple technocratic solutions. Simply put, there are limits to how much interest rates can be increased.
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