The current economic scenario globally presents a difficult choice for central banks. The worldís super-economies seem to be in a slowdown, with the US economy possibly having tipped into recession already. However, globally, inflation has remained firm, defying economic logic. This makes policy formulation by central banks throughout the world challenging. It is no different for RBI.
The Indian economy has been facing slowing production trends. Consumption demand, especially of interest-sensitive consumer durables, has slowed significantly. Consumer durable goods production witnessed de-growth of 1% in April-February 2008, compared to a 9.7% growth in the same period last year. Even as consumer non-durables production held relatively strong, overall consumer goods production is lower in 11 months of 2007-08 compared to last year.
And demand is likely to weaken further. First, the lagged impact of monetary policy tightening will continue to bite. Along, with higher interest rates, the recent spike in inflation (that too in food items) is capable of reducing consumption expenditure allocated for non-essentials, which is largely discretionary. On the other hand, the booming stock market had led to a sharp increase in consumer perceptions of wealth. With the recent stock market dip, this feel-good factor is likely to be on the wane, thereby reducing consumer confidence and discretionary spending.
It is widely acknowledged that the Indian economyís unprecedented boom has been a result of soaring domestic demand, even if the big contributing factor was investment demand rather than consumption demand. The current economic cycle, starting from around 2001-02, witnessed a sharp rise in investment demand, with Indiaís gross domestic investment as a percentage of GDP rising from 22% in FY02 to around 36% now. More importantly, even as there were signs of weakness in consumption demand on the back of tighter monetary policy, until recently investment demand had held strong. However, in January 2008, the capital goods sector clocked a disappointing 2.3% growth, the lowest in nearly six years. Growth in this sector did recover to around 10.1% the following month, but was still lower than the average growth of 17.5% in the first 11 months of 2007-08.
Investment demand, like consumption demand, is also likely to weaken further. Any direct impact of the global credit market crisis on Indian financial institutions is unlikely, as they have practically no exposure to US mortgage-backed securities and other problematic credit market instruments. However, the global credit market crunch and quantitative restrictions on