Column : Both growth & inflation are concerns

Written by Indranil Pan | Updated: Apr 21 2010, 01:19am hrs
The rapidity with which the Indian economy has rebounded has surprised many. Consumer and producer sentiments are upbeat and most estimates indicate that we are headed for 8% growth in the new financial year. Industrial production has been above the 15% mark for the last few months. But this rapid recovery in the economy has also brought forth the challenge of higher inflation. The inflation was mostly supply-driven from the food side but RBI had been consistently echoing a worry that this may soon lead to broader, higher inflationary expectations. Over the last few months, RBI had been placing increasing emphasis on the trends in the ex-food manufactured products inflation to gauge the demand side pressures building up in the economy. And the inflation in this segment has been on the rise over the past few months. In March, after the inflation reading of this group was at 4.22%, RBI lost patience and hiked the reverse repo and repo rates by 25 bps in an intra-policy move, following up on a phased 75 bps increase in the CRR on January 29.

The inflation for the ex-food manufactured category has now moved up to 4.72% and is expected to climb higher as domestic steel manufacturers hike prices and economic conditions remain strong. The CPI inflation for industrial workers is even higher, at around 13-14%. And it has been clearly laid out by RBI that the current monetary policy parameters are more akin to a crisis-struck economy than an economy that has rebounded sharply. The real policy interest rate in the Indian economy is also a very high negative of around 6.5-9% depending upon the measure of inflation chosen.

Thus, there is unanimity amongst observers of the Indian economy that RBI will continue to adjust policy rates upwards with headline WPI inflation expected to average at around 7-7.5% in 2010-11. The real debate is on the pace of the adjustment. In my opinion, RBI is already behind the curve, judging by the extent of the negative real interest rate and also the historical pace of adjustments that were employed when headline WPI inflation was as high as it is today. However, it is improper to blame RBI for this as it would have been difficult to justify monetary tightening in an atmosphere of uneven economic growth that was broadly led by fiscal stimulus.

Even though the latest IIP growth and headline WPI releases indicate some softening, RBI is unlikely to stop in its tracks. The strategy of RBI is to continue to anchor inflationary expectations and move closer to the neutral zone of monetary policy. I expect RBI to front-load the monetary policy actions in the first-half of the financial year. After reaching the neutral zone of around 4.0-5% on the reverse repo rate, RBI might be seen pausing to assess the implications of its past actions. In my opinion, the global economic dynamics, the dynamics of the foreign capital flows and inflation-growth combine for India will determine the future pace of tightening.

However, even as RBI might appear to be behind the curve, it will be difficult to see them hurry too much to play catch-up for the fear of hurting growth, especially in an atmosphere of continuing global uncertainties. Globally risks pertaining to sovereign debt levels exist as do threats to the sustainability of the ongoing growth momentum. Should any of these risks materialise, domestic growth could once again come under pressure. Further, even as broad indications point to a normal monsoon, RBI may be hesitant to push forward aggressive policy rate hikes before a confirmation is obtained on this. Further, growth dynamics from the consumer side indicate that there could still be some hesitation in calling the revival in consumption demand as fully sustainable, especially if interest rates were to be raised aggressively. Private expenditure demand is yet to revive in any significant manner, evident from the still muted growth in non-durable consumer goods and any sharp policy tightening at this juncture may dampen the nascent private expenditure demand.

Further, any sharp increase in policy rates could complicate policymaking, especially because it may conflict with RBIs current objective of containing surplus liquidity. Aggressive rate hikes by RBI could attract larger amounts of interest sensitive debt flows, and push for a greater appreciation of the rupee. This is not desirable as the rupee is already overvalued by around 12% and any further appreciation pressure might hurt exports. But, if RBI intervenes to contain the appreciation pressure it will lead to challenges in managing the excess rupee liquidity generated. This is especially as MSS issuances may not be an option with a large supply pressure on central government borrowing.

RBI can only afford to take small steps in its attempt to push the policy interest rates to the neutral zone. A gradual tightening of monetary policy is likely to be the best bet at the moment in order to anchor inflation expectations and also provide the needed push to sustain economic growth.

The author is chief economist, Kotak Mahindra Bank. These are his personal views