Killing the inflation monster is relatively easy when the underlying causes are primarily demand-side. If an economy grows too quickly due to rising aggregate demand, firms tend to respond initially by employing more workers, which drives up wages and other input costs. As capacity utilization increases to levels that reduce the amount of idle productive resources, firms will then begin to raise prices. The standard tool of central banks to fight “demand-driven” inflation has been to raise interest rates. By making borrowing more expensive for businesses and households, demand for capital and consumer goods as well as workers declines, cooling an overheated economy.
The problem, however, arises when inflation is not demand driven. Data from the Indian Economic Monitoring Center shows that the unemployment rate in March was 7.6%. That’s pretty high, considering a concurrent drop in the labor force participation rate (LPR) to 39.5%. If even a small workforce is struggling to find jobs, this is hardly indicative of a tight labor market. The latest RBI manufacturing survey shows overall capacity utilization by reporting firms stands at 72.4% for October-December. Although it is the highest in 10 quarters, it is below the long-term average of 75% from 2008-2009 to 2018-2019. On the contrary, it points to a recovery from a deep downturn that began in 2019-20. And the recovery is not strong enough to induce overheating, unlike the United States, which had an unemployment rate of 3.6% on an LPR of 62.4% in March. Furthermore, the fact that annual wholesale inflation in March, at 14.55%, was more than double the rate of 6.95% at the retail level suggests limited pricing power for businesses: conditions Current demand conditions do not allow them to fully pass on the higher costs. from producer to consumer level.
What most countries, including India, are experiencing today is “supply shock” inflation. There have been too many supply chain disruptions over the past two years, caused first by Covid-triggered lockdowns and now by the Russian-Ukrainian war. Following one after the other, they proved to be persistent rather than transitory, causing what economists call a leftward shift of the aggregate supply curve and pushing up prices for the same or even lower levels of demand. Those who criticize the RBI for being “behind the curve” should know that there is little central banks can do about inflation caused by supply-side factors. If interest rates are themselves a cost, wouldn’t rising risk aggravate inflation by hampering supply? And how does cooling something that isn’t hot really help? Policymakers can perhaps learn more from the stagflation decade of the 1970s. Moreover, it was geopolitical supply shocks that defied simple technocratic solutions. Simply put, there are limits to raising interest rates.
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