What is the right price of money?

India's Inflation Is a Lesson for Fast-Growing Economies

By Alex Frangos

For many emerging nations that boast enviable rates of growth, there is a cautionary tale in India, which is paying the price for letting inflation infect its economy.

The country's central bank, the Reserve Bank of India, meets this week to decide whether once again to edge up its benchmark interest rate—now 8%—in the continuing tug-of-war between rising inflation and sliding growth.

India's problem of inflation rates approaching double-digit levels is playing out to a lesser degree in other developing economies. Amid easing Western demand for the emerging world's goods, growth is slowing in countries such as China, South Korea and Brazil, where prices are being driven up by food-supply shortages, consumer demand and wage increases.

That puts central banks in a pickle. Policy makers could lift rates to snuff out inflation, but they risk plunging decelerating economies into a serious slowdown. If they don't tighten policy, inflation could get out of hand, requiring sharper rate increases down the road.

Brazil has indicated more concern with slowing growth than with inflation. The country's central bank cut interest rates last month despite inflation accelerating to 7.2% in the year through August, a perilous combination in a country with a history of hyperinflation.

Brazil is acting in the belief that monetary policy needs time to take effect. Once the interest-rate cut works its way through the economy, the thinking goes, slowing growth will have snuffed out inflation. Gauges of future growth, such as manufacturing surveys and export orders, point to a slowdown, and the central bank believes that cutting now will help prevent a downturn from being worse in several months.

China and South Korea are in similar situations. Indexes that measure manufacturing have dropped to their lowest levels since the financial crisis and indicate a slowdown is afoot. Yet inflation in China remains at an uncomfortably high level. Government data Friday showed China's consumer-price index rose 6.2% in August from a year earlier, but decelerated from July's 6.5% increase. In South Korea, consumer prices were 5.3% higher in August than a year earlier, the fastest rate in three years. Its central bank last week left benchmark interest rates steady.

In India, 11 interest-rate increases in 18 months have taken a bite out of the world's 10th-largest economy, with business confidence sinking and growth slowing five quarters in a row. But the increases haven't reduced the inflation rate.

Rising prices have sparked concerns that inflation is deeply embedded in the economy, meaning more inflation-fighting is necessary even as the global recovery slows.

Arguably India's situation is worse than most, putting it in the position of having to lift interest rates when under normal circumstances the prescription would be staying pat or even cutting rates to spur growth.

There's debate about the quality of India's inflation measures. The most closely followed Wholesale Price Index, while down slightly in July, has hovered just below 10% for months, twice the target level that economists and politicians say is healthy. More troubling, inflation expectations—or the view among consumers and businesses of where prices are heading—are above 12%. At that level, economists worry, people alter their behavior and spend their money quickly, because they believe prices will keep rising. That boost in spending itself spurs more inflation, feeding a cycle that can be broken only by an economic slowdown. That is what Paul Volcker's Federal Reserve had to usher the U.S. economy through in the early 1980s.

There are many theories about what caused India's predicament. Some point to bad harvests that sent food prices skyrocketing. Others cite the unintended consequences of the increase in rural school-participation rates, which has reduced the supply of child labor, putting pressure on wages to grow. Rising prices put pressure on employers and government wage regulators to increase pay.

Some blame the central bank.

"There's an excuse, 'Oh, we have a bad harvest' or 'Oh, there's been a global commodities price shock' or 'Oh, it's just the fault of the crude oil.' I think that's a big mistake. This has been a persistent problem, and it reflects a failure of macro policy," said Ajay Shah, an economist at the National Institute for Public Finance and Policy, a government think tank in New Delhi. Inflation has been above the government's informal target since 2006, he said, long before food prices jumped.

Mr. Shah said Duvvuri Subbarao, governor of the Reserve Bank of India, has undermined inflation-fighting efforts by questioning whether rate increases even work. Six days after lifting rates in May, for instance, Mr. Subbarao said monetary policy is "an ineffective instrument for reining in inflation emanating from supply pressures. It is unrealistic, under these circumstances, to expect the Reserve Bank to deliver on an inflation target in the short-term."

The Reserve Bank has gotten more aggressive in recent months, surprising markets with a series of half-percentage-point rate increases. In a Sept. 3 speech, the RBI's executive director, Deepak Mohanty, acknowledged that inflation has become "generalized" in the economy, but predicted the rate increases would begin to bring down inflation later this year and in early 2012.

India's economy is paying the price. Growth in the country's recently booming auto sales has tailed off. Politicians who counted on 10% annual growth to rival China are confronting an economy growing below 8%. While a robust pace in global terms, that is too slow to deliver on promises of poverty reduction and job creation.

"You have to pay a painful short-term decline in business-cycle conditions to be able to exorcise this inflation," Mr. Shah said.