Corporate India remembers too well the repercussion of the Reserve Bank of India's (RBI's) last savage tightening, and the scars of that policy do not as yet show any signs of healing. Rangarajan's severe clampdown on the money supply in 1996 sent interest rates sky-high, created the credit crunch, and has been blamed for the slowdown in growth. Will there be a repeat performance this year? Kamal Sen, economist with DSP-Merrill Lynch, believes the RBI has little option but to tighten policy, given the fact that inflation is high and climbing. "The consumerprice index was as high as 12.4 per cent, taking the July figures," points out Sen. He says that a stagflationary scenario, with low growth, high inflation and high interest rates is very likely.

The last time M3 growth went beyond 20 per cent was in 1994. Year-on-year M3 growth was above 17 per cent from January 1994, crossed 20 per cent in September, and stayed around that level before slowly falling back after April 1995. In 1995-96 the RBI tightened money sharply.

During 1994-95, the wholesale price index (WPI) saw a slow and steady increase from 9.1 per cent in January 1994 to over 11 per cent in April and May. It fell briefly thereafter, but remained above 9 per cent till July 1995. During 1994-95, prices of primary articles increased by 14.3 per cent; the fuel group index went up by 10.3 per cent, and the price index for manufacturing saw a 10.6 per cent rise. The great squeeze in 1995-96 resulted in the WPI growth coming down to 5 per cent. That year's monetary tightening is also reflected in M3growth figures, which fell to 13.7 per cent in 1995-96 after registering an increase of 22.3 per cent in 1994-95.

Additionally, there were several signs that the economy was overheating in 1994-95. The gross domestic product (GDP) growth was 7.8 per cent, non-food credit increased by 29.8 per cent, industrial production was up by 8.4 per cent.

In contrast, the current year's scenario is very different. This year so far, the increase in WPI is 8.1 per cent, GDP growth is expected to be around 4.5 per cent, year-on-year industrial production in June was up 5.2 per cent, and non-food credit is up 15 per cent. Taken together, all these indicators do not add up even remotely to an overheated economy.

Especially because the growth in the index for manufactured prices is up just 5.4 per cent, that for fuel is up 2.5 per cent, and the lion's share of the contribution to inflation is owing to primary articles whose index has increased by 14.5 per cent. That indicates current inflation is owing to supply problemsin agricultural commodities. As Anindya Chatterjee, head of research in ANZ Grindlays Bank points out, few corporates have pricing power today. With huge idle capacities, manufacturers may have no option but to absorb higher raw material and wage costs. Abheek Barua, economist at SS Kantilal Ishwarlal points out that M3-induced inflation is usually uniform over a spectrum of commodities, and the current inflation is more owing to agricultural bottlenecks. If the current bout of inflation has little to do with the increase in money supply, where's the need to tighten money?

What about interest rates? Short-term interest rates are high, with 91-day T-bill at 9 per cent, and the 364-day T-bill at 9.6 per cent. This is comparable to short-term rates in mid-1995-96, before they shot up to 13 per cent a year later as a result of the credit crunch. Long-term rates, however, are lower, with prime lending rate (PLR) at around 13-13.5 per cent. Contrast the 1994-95 PLR of 15.5 per cent. This shows that therecontinues to be a lot of slack in the economy.

Sen, however, points out that with non-food credit growing by 15 per cent, that slack may not exist for long. Add to that the lack of external funding, and it is clear that the pressure on the banking system to provide the funds is going to be tough. Typically, there should be some easing due to the lower requirements of government funding in the next few months, but usually government requirements start increasing again from February onwards. That's when Barua expects interest rates to start rising. In other words, there's a fair chance that interest rates are going to rise anyway, whether the RBI tightens money or not.

So should the RBI adopt a tight money policy now? While it's true that the current inflation is due to supply constraints, recent reports on the kharif crop are not encouraging. Chatterjee points out that higher food prices may lead to demands for higher wages, which will impinge corporate profits since they cannot pass on the costs. On theother hand, if the RBI tightens money supply, interest costs will inexorably rise. One way out, suggests Sen, is to import agricultural commodities in short supply, cooling inflation down. The upshot is that the RBI should be extremely careful about raising interest rates and choking off an incipient recovery in industry, merely on the strength of the inflation indices. However, the November state elections could be crucial, and if their results are not favourable to the BJP, a tight money policy may well become politically inevitable.