Given the sense of inevitability of continuing tightening at its monetary policy review yesterday, RBI will have sewn up the arguments of its inflation-fighting stance preparatory to another 25 basis points (bps) hike to 8.5%, together with a statement of its commitment to carry on with ?its unfinished task of taming inflation?.
Enough has been written now on slowing growth and the growth-inflation tradeoff to make reiteration redundant. But it might be worth reiterating a couple of facets of this tradeoff, which do not seem to have been highlighted commensurate to their importance in determining the policy stance.
One is the rapid obscurity of some economic concepts associated with monetary policy. In particular, discussions on how far beyond the neutral rate (or as RBI now prefers to call it, the non-inflationary rate of growth, NIRG) seem to have gone off the radar screen. It might be useful to provide a fresh interpretation of the neutral rate.
Estimating the neutral policy rate (and, as an input into this, potential output) is a notoriously difficult empirical exercise, and the cost of funds are a rough and ready indicator of the slowdown of demand and economic activity, as a measure of the deviation of actual growth from potential output. The more policy rates diverge from a presumed (and unknown) neutral level, the less the traction that rate increases have on cost of bank funds.
This is a paradox of the later stages of rate increases. Shorter-term interest rates have not moved up significantly since early August (post the 50 bps hike in rates), despite policy rates having increased by 75 bps over this period. What does this signal? That demand for funds from borrowers remains weak, and that despite a tightening of international liquidity, rates of one-year commercial paper and certificates of deposits, which are nearest maturity proxies for the cost of funds for banks, have nudged up only 10-15 bps during this period. This was presumably one of the reasons for the failure of most banks in increasing their base rates and PLRs after the last policy rate increase in mid-September.
This does not mean that there has been little impact on rates. The benchmark 10-year sovereign yield has increased almost 60 bps over the period. This has its own set of impacts. The cost of borrowings for the government has increased and, at a more peripheral level, banking trading profits will be impacted. Given the already weakening growth and credit momentum, this also diminishes the capability of banks to provision for stressed assets and increasing non-performing assets (NPAs), which are an inevitable by-product of the economic downturn.
The second issue is the transformation of feedback loops associated with the conduct of monetary policy. The classic case where monetary policy is inherently designed to intervene is in the wage-price spiral loop that inflation, and more potently, inflation expectations set in motion. Prolonged inflation leads to wage increases, partially through mandated indexation such as dearness allowance and then through salary negotiations in the presence of skill imbalances, which further feeds into price pressures.
While there is inevitably an element of this in the current situation, another cycle has begun to become more dominant. Slowing growth has meant a drop in tax collections, as direct and indirect taxes numbers until September testify. This is likely to bloat the governments? fiscal deficit, forcing further market borrowing, with attendant higher costs. Higher sovereign borrowings make equity markets nervous, keeping the rupee weak, further reducing the attractiveness of Indian markets, impacting, among other things, the government?s disinvestment programme.
The biggest negative impact of a weaker rupee is a reinforcement of inflation through an increase in prices of imported commodities, particularly crude, which partially negates the effects of both weaker domestic demand and a drop in global commodity prices, necessitating that monetary policy work that much harder to fight inflation.
Is the wage-price spiral a larger threat at this juncture than the slowdown?fiscal slippage?foreign liquidity one? Probably not. While acknowledging that structural rigidities in India can still keep the cycle potent, the latter now probably needs to come centrestage. Most demand signals indicate that it can only get worse: a large part of current demand is probably part of legacy momentum, which will slacken in the coming months. There is reason to believe that GDP growth in 2011 will be closer to 7% than to the persisting official forecasts close to 8% and a likely RBI forecast of 7.5% ?with upward bias?.
A combination of falling capex and a weak rupee might actually conspire within a very short timespan to reignite inflationary pressures, even as growth remains low. This would defeat the entire purpose of the current stance of monetary policy.
The author is senior vice-president, business & economic research, Axis Bank. These are his personal views