BREAKINGVIEWS - India is behind curve on inflation

Radishes are seen piled up as customers wander at a wholesale vegetable market on a cold morning in Chandigarh January 10, 2011.

-- The author is a Reuters Breakingviews columnist. The opinions expressed are his own --

By Hugo Dixon

LONDON (Reuters Breakingviews) - India is behind the curve on inflation. It's not just that weekly food inflation has hit 18 percent; the current account deficit is also uncomfortably high.

The authorities need to get a grip, even if that means sacrificing 9 percent GDP growth in the coming year. Structural reforms, not loose policy, are the only sure way to sustain rapid growth.

An immediate cause of the inflation spike was a sharp rise in the price of onions, an important element of the Indian diet.

As the next crop comes through in a couple of months, the headline rate will drop dramatically.

But there are increasing signs that inflation is starting to become entrenched more generally -- and that this, in turn, is a result of India's economy growing faster than it can sustain.

Look at the current account deficit, which widened sharply in the September quarter, and which Goldman Sachs estimates will hit 4.3 percent of GDP in the year ending March 2012. Overall wholesale price inflation in November was 7.5 percent. Some economists also think India may be in the early stages of a wage/price spiral.

Apologists point out that it is only natural that wages should rise in such a rapidly growing economy; and that as Indian diets get richer, the prices of items like milk and meat will rise.

It is certainly healthy for the country to experience big shifts in relative prices. But that doesn't mean it should be happy with sharp increases in average prices -- especially since global inflation is also on the rise, and India will be badly hit by high crude oil prices.

The Reserve Bank of India, the country's central bank, has tightened monetary policy following the dramatic loosening in the wake of the global financial crisis.

The government has also reined in fiscal policy. But with the repo rate at 6.25 percent, real interest rates are negative; and the general budget deficit, which includes the states as well as central government, is expected to end the current financial year at a fairly high 7.5 percent of GDP.

Both the central bank and the government will probably apply further light touches to the brakes when the quarterly monetary policy review and the budget are announced this month. But there doesn't seem to be much urgency to get ahead of the curve.

This is largely because the government has become addicted to the country's near-9 percent growth rate. Indeed, some influential voices now argue that a medium-term inflation rate of 6-7 percent would be a reasonable trade-off if that is what is needed to sustain fast growth.

Such thinking is misconceived. There is no medium-term trade-off between growth and inflation. If a country is growing at above its productive potential, as Milton Friedman rightly argued, inflation will accelerate: the 4-5 percent inflation policymakers previously thought reasonable will become 6-7 percent inflation and then 7 percent plus, which is where inflation has been stuck for over a year.

If inflationary psychology gets entrenched, it will be expensive to uproot. International investors, on whom the country relies to finance its current account deficit, could also take fright if they perceive the authorities have a cavalier attitude.

India may well be able to sustain 9 percent GDP growth over the next decade, but only if it presses ahead more vigorously with supply side reforms -- to combat corruption, free up labour markets, boost infrastructure investment and the like.

In the meantime, it would do better to settle for lower growth. It would also be advisable to strengthen the independence of the RBI, which is susceptible to interference by politicians, and set a formal inflation target. Otherwise, there will always be a temptation to play politics with inflation.

(Editing by John Foley and Sarah Bailey)