Column: Pencil in another rate hike

Written by Dharmakirti Joshi | Updated: Nov 4 2013, 23:21pm hrs
One look at the accompanying heat-map and you understand why they often repeat that pictures-are-worth-a-thousand-words dictum. No matter how you measure inflationusing the yardsticks of CPI, WPI or GDP deflatorit has remained in the red zone, or above Reserve Bank of Indias (RBI) comfort level of 5% for many years now.

In India, assessing inflation can be confusing because the measures vary in terms of periodicity, coverage and even objective; at times, they even move in opposite directions.

Take, for instance, FY10, when wholesale price index or WPI-based inflation collapsed to 3.9% as domestic fuel and commodity prices crashed in line with the global economy. In that year, consumer price index or CPI-based inflation remained stuck at over 12%, which was the highest since FY01. Hence, the dip in WPI inflation in fiscal 2009-10 was a one-off and WPI kissed double digits in the following year.

But despite their limitations, all the three measures are unambiguous in their basic message: the price fire is far from being doused. When consumers encounter high inflation year after year, they begin to believe it is here to stay. In other words, inflationary expectations become entrenched.

So, predicting what a central banker would do when he looks at the heat-map is easy. Policy rates will be raised to tame prices. And if inflation is accompanied by high growth, the decision is a no-brainer. But thats not the case in India at the moment. GDP growth has slipped sharply to 5% in the last fiscal and prospects for the current one are worse. CRISIL expects growth to slow further to 4%.

This creates a dilemma: should RBI focus on growth or high inflation This is hotly debated every single time before the announcement of the monetary policy. We argue that a sluggish economy does not mean RBI should become tolerant of high and rising inflation. Therefore, the decision to raise interest rates on October 29which implies that risks from high inflation outweigh risks from low growthwas appropriate.

True, demand is not behind current inflationary pressures measured through WPIprivate consumption demand grew at a measly 1.6% in the first quarter of this year and investment demand continues to be extremely weak. Core inflation, which captures demand pressures, was muted at 2.1%, while inflation in non-core components (food, fuel, electricity) of WPI, which reflects supply shocks and structural rigidities, was at 10.3% in September.

Although core inflation rose marginally in September, this still does not reflect demand pressure. The rising core inflation was a result of firms passing on at least some increase in input costsarising from a weak rupee and a hike in diesel/electricity prices owing to extreme pressure on marginsto the consumers. This has raised WPI-based core (non-food manufacturing) inflation to 2.1% in September from 1.9% in August. If costs are being passed through even in a weak demand environment, the transmission would accelerate when demand picks up.

Inflation in non-core components is typically ignored by central banks because of their highly volatile nature and one-off impact that wears off gradually. But this is not the case in India. Not only does the non-core component have a high weight (in WPI it has 45% weight) but some parts of it have also witnessed persistently high inflation. This suggests that if demand were to pick up, such high inflation in non-core sectors (many of which are inputs in production process) would get passed on to the core inflation.

A good example of persistence of non-core inflation is food inflation, which averaged over 10% in the last 8 years compared with the below 5% figure in the preceding decade. Food inflation is volatile and depends a lot on monsoons. So, it is likely to head down from the elevated levels it is at currently on the back of good monsoon this year.

But what is indeed worrying is that, over the years, the volatility of food inflation is around a higher average (10%) and not around 5% as it used to be. So, food inflation has structurally moved up and has become persistent in nature. Even the fuel category (electricity and diesel) will witness high and rising inflation for some more time as suppressing prices may no longer be possible due to mounting fiscal pressures.

The inflation story gets more worrying when we focus on consumer price inflation. Not only is CPI inflation high, but even the core CPI is at over 8%. Even though WPI has a long history, it ignores the increasingly important services sector, which now accounts for 60% of the economy. CPI is new, but more representative of the inflation faced by consumers. A dipstick test with consumers will confirm that. I believe that CPI, despite its short history, would be a better gauge than WPI which does not have the same consumer connect.

So, how long and by how much should the interest rates be raised to keep inflation from getting generalised and to anchor expectations

There is no easy answer. US Federal Reserve Governor Ben Bernanke had once remarked on complexity of monetary policymaking: If making monetary policy is like driving a car, then the car is one that has an unreliable speedometer, a foggy windshield, and a tendency to respond unpredictably and with a delay to the accelerator or the brake.

In todays environment, the noise-to-signal ratio is very high no matter what data you look at. To paraphrase the Bernanke analogy, the Indian cars speedometer is more unreliable and its windshield foggier.

Interest rate decisions will, therefore, be more a work of art and judgement. When thats the case, even an experienced driver can err.

Nevertheless, going by the tone of the monetary policy review this week and the increasing focus on CPI, we are pencilling in another rate hike.

The author is chief economist, CRISIL