As we progress into 2011-12, inflation woes continue to weigh down on the economy. Inflation, which remained high at 9.4% in the first quarter of 2011-12, is expected to surge to double digits in the second quarter. RBI?s year-end target of 6% (which is still above their comfort zone) appears tough to achieve despite 10 rate hikes and an emerging consensus that growth is set to moderate. CRISIL expects GDP growth to slow to 7.7-8.0% in 2011-12 from 8.5% in the previous year. This has generated debate on whether RBI should pause rate hikes now that demand has started moderating, or should it continue to raise rates to clamp down on inflation.
I expect the central bank to continue with its tight monetary stance and go ahead with a rate hike of 25 basis points in its July 26 policy as inflation continues to be stubborn, latent and unpredictable. While current inflation is already high, inflationary expectations (as revealed by the RBI?s surveys of inflation) too remain elevated. The Economist ranks India as the fourth-most overheated economy among 27 emerging economies. And yet, the truth of the matter is that even at over 9% levels, inflation has actually been artificially suppressed. The domestic fuel prices are only partly aligned to the global crude prices that have sharply risen from the lows reached during the worst phase of the global financial crisis in 2009. Food inflation averaged at over 15% per year between 2009-10 and 2010-11. This has exerted upward pressure on wages and can feed into general inflation, raising the risk of a wage price spiral. Inflation is expected to decline in the second half of 2011-12, but is unlikely to drop to levels that could offer comfort to policymakers. Inflation, even if it heads down, is definitely not out.
Inflation has remained elevated partly because it continues to be driven by food, fuel and commodities, which cannot be effectively tamed by the monetary policy. Normal monsoons have aided the continued softening of food inflation, but the movement of fuel and commodity prices depends on global conditions, which are always fraught with uncertainty. With core inflation touching 7.5%, the transmission of high food and commodity prices into the manufacturing sector has already started. The recent hike in diesel prices, which was inevitable, is likely to speed up this transmission further, as diesel has a strong correlation with core inflation. This transmission can only be reined in by raising interest rates, which would help curtail demand in the economy.
The current episode of inflation can easily be classified as the most troublesome and complicated one in the last two decades. The long-term trends point towards an upward structural shift in inflation. WPI-based inflation averaged at 5.2% during the 10 years starting 1994-95. But, during the period between 2005-06 and 2010-11, which marked the high growth phase of the Indian economy, the average inflation rate went up to 6.2%. India?s GDP growth averaged at 8.6% per year during this period despite the global recession in 2008-09. In 2008-09, inflation averaged at 8.1%, largely driven by fuel, commodities and food. Core inflation had also risen to 5.7% during the year. In the following year, 2009-10, the inflation rate collapsed to 3.6%, as domestic fuel and commodity prices crashed in line with the global economy. Overall inflation in 2009-10 fell, despite food inflation at above 15%, due to negative fuel and core inflation. In 2010-11, with average inflation at 9.6%, the inflation situation had worsened as compared to 2008-09. Food inflation was high at 15.8%, fuel in double digits and core inflation at 6.2% in 2010-11. In the first quarter of 2011-12, although food inflation has come down to single digits, fuel and core inflation have risen.
Is it possible for the 2009-10 scenario, when inflation came down sharply, to be repeated in 2011-12? Not unless global crude and commodity prices crash the way they did after the Lehman crisis. The worsening sovereign-debt crisis in Europe would represent another important downside risk, particularly if it spreads from peripheral Europe (Greece, Portugal and Ireland) to its core (Spain and Italy). Although risks to the global economy have risen of late, it is hard to visualise another global recession, and a consequent slide in commodity and crude prices. No wonder that inflation expectations by major forecasters remain elevated.
RBI has raised repo rates by 275 basis points since March 2010. But the repo rate at 7.5% is still below the pre-crisis level of 9% in 2008-09?a year when inflation was not as stubbornly high as it is today. This shows that RBI has exercised restraint in raising rates in view of the fragility of the global economy. As I pointed out earlier, GDP growth will slow down this year as the impact of past tightening comes into effect. According to CSO data, investment growth is also slowing down. We believe consumption growth too will moderate, but will still remain healthy. This slowdown in demand is critical for limiting the spread of inflation. The danger, otherwise, is that high inflation could become a major risk to the medium-term growth prospects of the Indian economy.
The author is chief economist, CRISIL. These are his personal views