Regardless of economics, or facts, most analysts have only one prescription for the Indian economy – raise interest rates!

As India has seriously entered the global world, the economic debate has also begun to take on an international flavor. There is talk of business cycles, overheating, anchoring of inflationary expectations, etc. A very welcome, and necessary, change from yesteryears when macro policy consisted of just controlling the growth of money supply.

The change in talk has not been accompanied by rigor in analysis. The discussion on an overheating Indian economy is illustrative. To repeat the obvious: overheating implies that economic growth is at unsustainably high levels; if allowed to continue, overheating would have an undesirable impact on inflation. Hence, it needs to be nipped in its infancy so that inflationary expectations are properly anchored. There are two logical connections here; first, that analysis should establish that the economy is overheating; second, the analysts should establish a reasonable connection between the magnitude of overheating and the magnitude of extra inflation. When pursuing this exercise, let us all be honest to admit that symmetry has to exist. If this honest exercise leads to a conclusion that the economy is underheating i.e. growing below potential, then monetary loosening is called for!

Some facts related to overheating (see table). For the twenty-three year period 1980-2002 the Indian economy grew at an average rate of 5.6 percent per annum. Post 2002, now for some six years, GDP growth has taken a step jump towards 8.5 percent. Is this 3 percentage point increase a sign of overheating? Not if accompanied by increased savings and investment; yes, if propelled by unsustainable borrowing. On this simple rule, there is no evidence of overheating as both saving and investment rates have increased by 10 percentage points each - from an average around 23-24 percent to an average of 33-34 percent. Accompanying the surge in growth, has been an equally surprising increase in employment growth from 1.8 to 2.8 percent per annum. Assuming no increase in productivity growth (an unreasonable but conservative assumption), the increase in growth rates of capital and labor would yield a potential GDP growth of an extra 3 percent per annum. Which means a growth rate of 8.6 percent per annum - the actual growth rate during the last six years (including an estimate of 8 percent in 2008/9) was 8.5 percent!

So no evidence of overheating in the last six years; yet the discussion by policy makers and investment bankers has been consistently that the acceleration in GDP growth has been a consequence of overheating; hence, the need, nay dire necessity, of controlling the side-effects of this heated growth, namely inflation. The GDP data just released indicates a yoy inflation figure (GDP deflator) of 7.6 percent compared to 6.1 percent in the same period last year. Is this a sign of overheating or much more a sign of imported inflation?

There is no premium, indeed discount, for not following the crowd. No forecaster, economist, or investment banker ever lost her job because she did not follow the herd. Even pink newspapers (perhaps especially) are prone to this benign foot-in-mouth disease. This very paper, in an editorial on Sept. 3, stated: "Once embarked upon [an anti-inflationary policy] such a stance must be followed to its logical conclusion, which means that as long as the inflation rate is above the comfort zone, policy rates must be raised" (emphasis added). Let us examine the sequence of expert logic: economy is over-heating, even though there is no evidence of the same (this is not to deny that certain sectors of the economy are overheating while also realizing that certain sectors are undercooked). If economy is not over-heating, then higher inflation could not have been caused by higher than expected economic growth. We all agree that inflation is high, and most sensible analysts attribute it to the high degree of imported inflation, especially for fuel. The specious argument is sometimes made that the recent 30 percent ($ 40) decline in oil prices will not affect inflation because we did not pass thru the full magnitude of the oil price increase. With each $ 10 decline in the price of fuel, the fiscal deficit is lessened by 0.5 percent of GDP. This lessening may not have an impact on inflation, but no one should argue that a decline in the deficit is inflationary.

Some numbers on commodity price inflation are revealing. The average decline from peak in energy, metals and agriculture has been around 25-35 percent (natural gas is half its value of just 2 months ago). With commodity prices declining, either because they were overbought, or because of "demand destruction", it does follow that inflation rates, which were brought up by imported inflation, will, over time, be brought down.

The logic of much that passes for analysis of the Indian situation, by both domestic and foreign analysts, is as follows. Inflation is high because there is overheating. We should therefore continuously increase interest rates until we see an inflation figure that we are comfortable with, say 5 percent. [See quote above]. This regardless of the fact that interest rates in India are already the highest in the world. GDP deflator in the first fiscal quarter averaged 7.6 percent, the repo rate is at 9 percent. The real rate: 1.4 percent. This conclusion about the highest real rates in India follows regardless of the price measure used, as long as different price measures are not used for different economies. It is true this statutory warning is ignored by most analysts!

It is a matter of historical record that the same arguments were made about the Indian economy, and Indian inflation, when commodity prices were on their upward march. It was Keynes who rather brilliantly said: When the facts change, I change my mind. What do you do, Sir? Obviously, us monetarists and wannabe Indian central bankers don't believe in anything Keynes said!