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Why is the economy overheated?

In the last twelve months, prices in the wholesale market rose by 5.4 per cent, writes DH Pai Panandiker.

india Updated: Nov 10, 2006 19:26 IST

In the last twelve months, prices in the wholesale market rose by 5.4 per cent. This seems to have convinced the Reserve Bank of India (RBI) that the economy is overheated and tempted it to increase the rate of interest. It however chose only to raise the repo rate which would do the least damage.

Few countries will tolerate such high inflation. The United States Federal Reserve raised the interest rate from 1.5 to 5.25 per cent because inflation had crossed three per cent. The European Central Bank cannot take even two per cent inflation and raised interest rates in spite of the likely drop in economic growth. China has been discouraging investment in housing because its economy is overheated and consumer prices have been rising at 1.5 per cent.

The first sign of overheating is high growth combined with high prices. In the quarter April-June our GDP growth touched 8.9 per cent, the highest in six years. Corporate sales are shooting up at 30 per cent and aggregate outstanding investment is 42 per cent higher than the level a year ago. At the consumer level prices have risen 6.8 per cent in August. Inflation confronted by the consumer is higher than what is revealed by the wholesale market.

Inflation has touched almost every commodity. But prices of food articles have jumped much more than other prices. Across the year, they were up 8.9 per cent. Prices of manufactured articles, in contrast, rose only 4.4 per cent. Inflation hit the agricultural sector harder because agricultural production has been nearly static although demand has been rising at more than 2.5 per cent. That makes agriculture responsible for nearly 30 per cent of the inflation at the wholesale level.

The reason why prices have been rising, particularly in the non-food sector, is excessive demand. The excess demand would be equal to the difference between investment on the one hand and savings plus net FDI on the other. The difference is funded from money supply expansion. Currently, savings by households and corporates are about 33 per cent of GDP and should not have created any inflationary pressure. But nearly 12 per cent of these savings are used by governments at the centre and the states to finance consumption expenditure. Savings therefore fall short of investment and generate inflation.

Central banks are most concerned about inflation because it can cause severe damage. Inflation redistributes incomes among different sections of society, disturbs foreign trade and payments, affects currency exchange rate, discourages savings and so on. Most central banks prefer to increase the rate of interest to check inflation. That discourages investment, principally in housing, and, to some extent, consumption of durable consumer goods. But the side effect is a drop in the rate of growth. The RBI has therefore increased only that rate of interest which will cause minimum disturbance. A more preferred way to check inflation is for governments to reduce their extravagant consumption expenditure. That would curb excess demand and ensure that growth remains high and inflation low.

First Published: Nov 10, 2006 19:26 IST