The Reserve Bank justified its latest round of interest rate hike on the ground that the inflation which began with strides in food prices had become more generalized. This time round, the prices of manufactured goods have gone up. In its statement the Reserve Bank referred to the “changing growth-inflation dynamics characterized by robust acceleration in growth and increasing generalization of inflation”. It is to fight the increasing generalization of inflation that rates hikes were seen as the best antidote.

Maybe, for the immediate needs a rate hike could bring down the inflation fever a little. If we look at the more disaggregated figures for inflation we will see that there are two distinct components of inflation. One is the primary goods price and the other is the rise in prices of manufactured goods. Only recently, since end of 2006 we had seen some rise in the prices of primary goods - particularly food items. It was piquant in 2008 when from February of that year food primary goods inflation was riding high from 7.3% in February it kept on inching up till November (2008). During all these months RBI kept on raising interest rates until October November when the economy had slipped into low growth areas and the industrial economy growth had gone in the negative zone.

This year as well food price inflation is soaring. In fact, it is hovering higher than in the comparable months of 2008 and at a level altogether. Manufactured goods inflation, on the other hand, had started creeping up only recently. And the overall manufactured goods inflationary was given a push upwards by the sharp rise in manufactured and processed foods prices. Many of the products of large industries like fertilizers paints and varnishes had seen falling prices. Where manufactured goods prices were rising these were due to general rise in wages, raw materials costs and interest. Industry admittedly was also facing a capacity constraint and therefore what was needed at the present was fresh investment to create additional capacity to de-bottleneck sectors which were facing shortages.

Obviously, these were symptoms of an economy growing fast and running into capacity constraints. Many surveys indicated that Indian industries were planning to make fresh investment for adding to capacity and produce more in the face of rising demand. In the intermediate stages prices were going up. However, there are sectors adding large fresh capacity and when these come on stream prices of industrial raw materials and intermediate goods (like, say, Steel) should witness a fall.

For controlling such spurts in prices of manufactured goods a hike in interest rate should be effective short term measures. It acts by choking off some demand and thereby we should be ready to see some moderation in growth of the economy. The Reserve Bank announcement that it would have much shorter review cycles for assessing the impact of its policy actions should be helpful in introducing any corrections in the short run. Therefore, any unwarranted contraction of rise in interest rates should hopefully be addressed in time.

However, what happens to the underlying and persisting high inflation rates of primary goods sector. What we see from disaggregated figures of inflation is that the inflation rate of this sector is not going down lower than 5% at any point of time. On the average it is around 8-9%. That shows a structural pressure on agricultural prices. The possible explanation is that the demand for food items is rising much faster than overall farm sector growth. As the economy is growing and more people get a little more income at the lowest level, they are asking for more food. This pressure cannot be stemmed by higher interest rate.

Possibly, the Chinese experience in this respect can have some distinct lessons. In a recent publication, Professor Pranab Bardhan (Awakening Giants, Feet of Clay, 2010) points out that between 1979 and 1984, that is, somewhat immediately after reforms began in China, Chinese farm output grew by 7.1% annually, as against 2.7% between 1970 and 1978. Overall, for the period from 1987 to 2004, Chinese agricultural output grew by 4.6% against India's 2.5%. Chinese productivity per hectare, Professor Bardhan writes, is double that of India in rice and some oilseeds, and one and a half times that of India in wheat. There, in all likelihood lies the secret of fairly stable price situation -or, at least, food economy in China—in recent years.

It looks as though, for stable prices in India what we need most is another round of farm sector revolution - in output, productivity and infrastructure. Along with this we need a programme for rural industrialization for better utilization of what we grow, because close to half of the harvest of perishables goods are lost due to lack of processing and cold chain infrastructure. These might sound like age old generalities. But then, without these structural reforms and step up in the farm economy we will periodically see inflationary pressures build-up and cycles of restrictive policy measures to temporarily throttle inflation. (IPA Service)