RBIs monetary policy stance is clearly loaded towards fighting inflation, with other objectives now secondary. But there are many puzzling, if not contradictory, signals on the growth-inflation dynamics. In setting the policy rate, given the noise and inadequacy of economic data, should RBI pitch the rate above or below what the more data rich decision might warrant
The key question is how, despite increasing signs of steadily faltering growth, can inflation, particularly retail inflation, remain so persistently high Saying that retail inflation is due to food and stems from structural bottlenecks is not completely satisfactory. While food inflation has indeed been higher than the other components of the CPI basket, and fuel price driven transport costs increases are logical, inflation in segments like clothes, home rentals, medical care, education all remain in high single digits, and the other miscellaneous segment in double digits.
If growth were indeed slowing, so would salary and wage increases, leading to tapering of disposable income; and concerns of potential job loss leading to reduction in discretionary spending and propensity to spend, which is at odds with observed segmental inflation. If households were spending more on food, fuel and transport, given a presumed lack of income growth, should not discretionary spends, and hence pricing power, come down So, the obvious question is: has growth really slowed as the data seems to suggest Or is there some other source of income which is not getting captured in the data
For RBI, this quandary must be clear and present. The experience of the sharp upward revision of the FY11 GDP numbers two years down the line, with earlier monetary policy having been calibrated to the lower figure, must weigh heavily on current RBI thinking. So might actual growth now be higher than the 5% projected by government bodies and the 4.5% projected by other analysts Are the IIP statistics, for instance, adequately capturing activities of the unregistered sector, even if not in the initial estimates, at least in the revised ones
One indication of this is to compare the growths indicated by the manufacturing component of IIP with the more comprehensive statistics of the Annual Survey of Industries (ASI), whose latest data is for FY11. Chart 1 shows that from FY07, ASI growth in sales volume has remained above IIP growth, in varying degrees, and had diverged sharply in FY11. Both are comparable in construct, neither is value-add.
Even more puzzling are inferences on underlying fundamentals from the multiple surveys RBI now conducts. Household inflation expectations remain persistently high, jumping 300 basis points up in the September quarter (chart 2). Is this a correct indicator for concerns of a potential wage price spiral The problem is that respondents might tend to have a recency hysteresis, with a bias for the most recent experience, and getting increasingly conditioned to a high inflationary environment. However, realisation of inflationary expectations into actual inflation involves both negotiating ability and the capability of acting on expectations. From the latter side, chart 3 shows a steep fall in the pricing power of corporates. This is measured by the ratio of output to input prices in the monthly HSBC Markit Purchasing Managers Index (PMI). Anecdotal reports of increasing uncertainty in the job market must also be severely curbing employee negotiating power. The only exception is the DA increases of public sector employees.
Trends on capacity utilisation and inventories (RBI OBICUS survey), on the other hand, show a sustained fall in capacity utilisation, moving in tandem with slowing sales (chart 4). Inventories of both finished goods and raw materials, in relation to sales, have moved up in the first quarter of FY14, compared to the average of FY13. Not an environment conducive for pricing power.
Finally, the move to increase financial savings through higher interest rates, particularly real rates. Very basic regression analysis suggests that growth is a more powerful explanator of household financial savings, compared to both CPI inflation and real 1- to 3-year deposit rates. This becomes even stronger for overall financial savings. We emphasise again that these inferences are more impressionistic, but do incorporate basic statistical rigour.
Tying all this up, should RBI err more on the side of growth or of inflation On the ground, both sharply slowing growth and persisting high inflation seem to ring true. However, data capture would probably be somewhat better for inflation. The crucial call is on the extent of potential spillover into generalised inflation. The bias for CPI inflation is down. This being the operative spillover channel, we think a tilt towards growth might be the optimal response at this time.
The author is senior vice-president & chief economist, Axis Bank. Views are personal