Despite possessing strong economic credentials, the Indian Prime Minister’s economic team has not yet been able to effectively address inflation.

Control on corruption has not been Prime Minister Manmohan Singh's strongest suit. And now, as we approach the one year anniversary of 9 percent plus inflation, it seems neither is his grasp of the economy.

For all of the criticism that Singh's government has weathered on corruption and inaction, economic credentials were supposed to be its Teflon armour. Dr. Singh, and his closest advisor, Montek Singh Ahluwalia, Deputy Chairperson of Planning Commission, are both economists from Oxford University. Dr. Singh's senior cabinet colleague, P. Chidambaram, is a two-time former Finance Minister and a Harvard MBA. The PM's Reserve Bank of India (RBI) Governor, D..Subbarao, is a former Finance Secretary and World Bank Lead Economist.

With such a star-studded team, it is perplexing why the prime minister is overseeing the fastest policy rate hikes amongst any major economy in the world, and yet failed miserably to control inflation. The latest October inflation figure is hovering just below 10 percent. The cumulative effect of aggressively raising rates thirteen times since early 2010 has also taken its toll on India's GDP. The RBI has cut the country's 2011 growth rate from 8 percent to 7.6 percent. 

Students of macroeconomics are taught very early on about the inverse relationship between interest rates and inflation. Higher interest rates reduce the supply of money in the economic system as the cost of borrowing goes up. This in turn reduces demand for goods and services, thereby dampening prices and inflation.

Since the beginning of 2010, the RBI has raised the repo rate, the rate at which commercial banks borrow from it, from 4.75 percent to 8.5 percent. It has further tightened money supply in the same period by increasing its reverse repo rate, the rate at which commercial banks lend to the RBI, from 3.25 percent to 7.5 percent. Both rates raise the opportunity cost for banks to lend to the private sector and individuals. Rampant inflation, however, has shown no signs of abating. Herein lies the problem.

It is now apparent that the government has been playing a double-sided game. It oversaw a withdrawal of money supply from the economy by raising interest rates, but simultaneously boosted its own spending to completely negate the effect of monetary policy. 

Government borrowing for 2011 has already overshot its budget by more than 10 percent due to increased spending and subsidy schemes. Instead of trying to contain food inflation, the government announced in October a 10 percent hike in the winter crop support price to farmers for 2011-2012.  The government's national rural employment guarantee program (NREGA), which provides 100 days of employment to all members of a rural family at a fixed wage, has fuelled rural wage inflation in almost all major states. The scheme is creating a shortage of workers in several sectors, so much so that there is now a clamour to suspend NREGA during crop sowing and harvesting seasons. NREGA has also slowed the natural migration of rural workers to urban centres. In Delhi alone, the wages for unskilled and semi-skilled workers have gone up by 50 percent over the last two years.  The government's 2011 budget deficit target of 4.6 percent of GDP is now wishful thinking.

Spending in itself is not a problem. Europe is currently trying to spend its way out of its crisis. What raises credibility issues is the government's intention and its dangerously faulty policy intervention.

By raising interest rates, the government directly impacts the formal sector of the economy. It increases the cost of capital for companies to borrow and make investments in factories and production. It also reduces the disposable income of the urban middle class, by making it more expensive for them to repay existing or new home, auto or personal bank loans. 

Rural Electrification Corporation, the government backed lender for power generation efforts, is leading a pack of Indian companies trying to offset higher interest costs in India by borrowing from China. The Reminbi’s universal acknowledgment of being an appreciating currency, thereby making future repayment even higher, highlights the pitiful plight of Indian corporates.

India's most visible export, Bollywood, is restricted to filming movies abroad in order to minimize rising costs.  Eros International, the co-producer of the blockbuster movie "Zindagi Na MilegiDobara" saved as much as 30 percent in tax breaks by shooting in Spain. IDBI Bank, the state-run lender for whom movie studios represent 16 percent of its loan portfolio, confirmed in a recent interview with Bloomberg Magazine that it was curtailing its film financing on the back of higher costs and expects the suffering in the business to continue.

The government’s irresponsibility has already jeopardized India’s entire aviation industry which is burdened by expensive debt costs, in spite of witnessing a 19 percent jump in passenger numbers this year. Kingfisher Airlines has had to cancel several flights in the last week, Jet Airways, India’s largest private sector airline, is trying to swap expensive rupee debt for cheaper dollar debt, and state-owned Air India has gone to the US Export-Import Bank for loan guarantees as it tries to cut its ballooning interest payments.

The flipside to the government's taxing monetary policy is its burgeoning spending program aimed at informal and rural India, sectors outside the mainstream economy. Such spending, cloaked in various rural schemes, is up at least 50 percent since 2009.

For this, rural India interest rate hikes bear little significance. It does not pay taxes and is untapped by the formal banking sector.  Higher incomes, via state subsidies and government largesse get spent on food and essential items, further squeezing urban middle class India who consume the same products which are now getting priced higher on strong rural demand.

The 2009-2010 Household Consumer Expenditure Survey which was released by the National Sample Survey Office in July 2011 confirms that rural poor are actually better off than urban poor, spending INR 599 per head per month versus their urban poor counterparts, who can only muster INR 453 per head per month.

For the country’s overall development, supporting rural India, where majority of Indians live, is certainly a just cause. However, this cannot be at the expense of urban and middle class India, which is the fundamental driver of India's economy in productivity terms.

If Manmohan's star team is not aware of its faulty policy repercussions then perhaps it is time for a back-to-school Economics 101 refresher. And if the team is trying to engineer a rural-urban economic divide by throttling India's middle class, then Manmohan better be careful. The embers from urban India's anti-corruption protests are still smouldering.

The views expressed in this article are the author's own and do not necessarily reflect Fair Observer’s editorial policy.