Column: Time to signal monetary easing

Written by Renu Kohli | Updated: Dec 17 2013, 10:31am hrs
Although an above-consensus GDP growth of 4.8% in September quarter has cheered everyone, the data reflects the growing severity of the impact of procyclical policies. The sharp deceleration in the services segment, more than half the production base, is much from fiscal contraction that is compounding the absence of industrial impulse and consumer demand. Another chunk of the economy, manufacturing, grew just 1%the pathetic recovery is in no mean measure from high interest costs in a low-demand environment, notwithstanding the exchange rate stimulus. So even while growth forecasts are raised following this upturn, the gathering force of contractionary policies will serve to pull down the momentum. Anticipating this spreading weaknessfiscal screws will be tightened more to maintain budget boundariesit is critical to reappraise the current macroeconomic policy framework. This is the time to signal monetary easing.

GDP data for the quarter just concluded showed manufacturing splutter back to life; but it only inched up 1% from a 1.2% contraction last quarter, and a depressing 0.1% last year. Net exports contributed 4 percentage points to the 5.6% growth in GDP at market prices. Private consumer spending grew 2.2%, half the rate clocked in the same period last year, and one-fourth that in 2011-12, indicating the secular decline in two-thirds of aggregate demand. Agriculture growth, at 4.6% year-on-year, did little to boost private consumption that added just 1.3 points to GDP.

Services growth slowed to 5.7%, from 6.2% the previous quarter and 1.4 points below last years corresponding quarter. Much of this deceleration came from fiscal austerity measures; growth in the community, social and personal services category sharply slowed to 4.2% from April-Junes 9.4%. This isnt all. Growth in the trade, hotels, transport and communication category was static vis--vis the past quarter and 3 percentage points below last years growth, reflecting that consumer demand continues to weaken.

Higher frequency data shows that the deceleration in services continued into the current quarter too. The HSBCs Purchasing Managers Index (PMI) for November showed a contraction for five consecutive months as services index remained below 50, the threshold separating expansion and contraction. Apart from post and telecommunications, all other five segments contracted with the sharpest fall observed in hotels and restaurants, testifying that consumer demand remained weak notwithstanding the traditional festive season. That November car sales fell after the festival spike in October is another confirmation of low consumer demand, as are reports of inventory stockpiles and production cuts by automobile manufactures. But to return to the services sector, the most severely impacted by fiscal compression, its decline dragged down the composite PMI; manufacturing showed expansion. These trends confirm that procyclical policy effects are becoming more forceful.

What lies ahead Trends in public finances strongly suggest that fiscal policy pressures will intensify. The fiscal deficit reached 84.4% of the budgeted target (71.6% last year) until October; net tax revenues grew 6.8% against the projected 19.3%, while expenditure growth (18.3%) maintained its pace vis--vis the budgeted target (18.2%). Although government spending rose sharply by 32.2% in October from Septembers 13.6%, as did net tax revenues (23.4% in October versus 7.3% in September), this pace cannot sustain through the remaining year given the commitment of retaining the fiscal deficit as budgeted, 4.8% of GDP. Tax revenues will fall short of budgeted targets with growth turning out weaker than expected so far, while divestment revenues are still up in the air.

In the September quarter, public spending contracted 1.1% and subtracted 0.1 points from total demand. For the current and next quarters, it appears that further cutbacks in public spending may be unavoidable; reportedly, cuts up to 0.7% of GDP in planned expenditure are contemplated and subsidy payments may be rolled over to next fiscal year. It is reasonable to assume, therefore, that fresh fiscal compression plus past lagged effects will trim down some GDP recovered in the forthcoming period. Note too that the magnitude of fiscal impact varies with the economic cycle, i.e. multiplier effects are larger at low points than when the economic cycle is on the upswing.

Under the circumstances, monetary policy must combat rather than exacerbate the effects of fiscal consolidation. A reversal in its tight stances at this point will relieve both producers and consumers somewhat and contain the spreading fragility. This may sound ludicrous to inflation hawks, but surely monetary policy must be anticipatory and move ahead of the economic cycle Indications are that the depreciation-caused inflation pressures, which appeared in the past two-three months, have subsided. The November PMI showed that the input price index dropped steeply to 58.0 from 64.5 in October. This reversed a five consecutive month uptrend, a strong indicator that price effects from a stable, recovered rupee are passing through since September-October. Moreover, the output price index eased tooto 51.9 from 55.3suggesting firms passed on the decline in input costs. But this price decline occurred in the manufacturing sector, while services sector firms actually increased their charges, implying a rise in consumer price inflation.

It is the central bank that has to decide whether to signal an easier monetary policy ahead. Will it bite this bullet It has been singularly devoted to price stability and, in recent times, more looked at consumer price inflation. Perplexingly, it shows little moderation in response to the prolonged decline in consumer demand and monetary tightening. The central bank needs to take a view on this and at this particular juncture: why the discordance in consumer price inflation and demand Is it the case that some components of consumer prices are immune to interest rate changes Is the weighting of consumer-price inflation an appropriate reflector of aggregate demand to which monetary policy is aligned Such questions need explanation and discussion. In the backdrop of the central banks renewed, tougher anti-inflationary stance, such a review and change in views may not be easy. But it is much needed at this low point in the economic cycle.

The author is a New Delhi-based macroeconomist