Signals from multiple economic and financial markets data released over the past week suggest that there is now a case for revisiting the pace and timing of the monetary policy tightening trajectory. There is sufficient evidence of a moderation of the economic growth momentum to argue for a pause on the policy tightening trajectory.
Inflation remains a key concern, but the WPI inflation data for July reinforced expectations of not just lower inflation but an actual fall in prices. More or less normal monsoons will help in moderating food prices over the rest of the year. Our understanding of the global economic environment suggests that prices of major manufacturing inputs and commodities are likely to remain steady for the near future. Our projections suggest that WPI inflation will probably fall steadily to around 7% by March 2011.
Sharply lower June industry growth might be the harbinger of a period of relatively subdued industrial activity, as is being signalled by various leading indicators, as well as our own channel checks with industry associations. The slowdown in merchandise exports in July, given the lags in domestic production, is another signal of a continuing impact on domestic manufacturing over the rest of the year. Weakness in both manufacturing and services was also indicated by the April-June 2010 corporate results, showing a compression of profit margins. Input costs had increased in Q1, but companies have largely not passed these on to consumers. This weakness in pricing power, somewhat at odds with a belief of high capacity utilisation levels, will continue, partially due to potential cheaper imports from countries with excess capacity, particularly China. Bank credit offtake in July remained negative, a sign of weak credit demand, probably due both to capacity slack and an uncertain economic environment.
Of greater concern, deposit growth has trended down almost secularly since mid-2009, an anomaly in the current growth situation, with expectations of concomitant increased savings having been belied. This drop has contributed to a continuing tightness in banking sector liquidity, more prolonged and severe than initially expected. We know that a presumed lack of foreign funds inflows has contributed to the squeeze, with faltering capital flows unable to bridge the current account deficit, evident from the continuing weakness of the rupee. Indian equities markets are already probably fairly-to-richly valued, and the uncertain global environment might lead to lower portfolio inflows. This was compounded by an unusual buildup of ?currency with the public? in the early fortnights of FY11, reportedly the result of high inflation forcing retention of cash in households for grocery buys.
A continuing constriction of deposits is likely to severely hamper credit delivery. Unless foreign funds flows pick up, or more domestic funds become available for banks, there is an increasing chance that a 20% credit growth might be unfeasible other than at a high cost to borrowers, an undesirable outcome for an economy that is operating with capacity bottlenecks in key segments. At the risk of oversimplification, there is no money available to banks, from depositors or markets, to fund credit delivery. If credit demand does pick up, then banks will try to attract term deposits. But the cost of these funds will increase, given the continuing and indeed increasing liquidity tightness that we foresee for the rest of the year.
Is it then time to pause on the calibrated trajectory of monetary policy tightening? The current economic, financial and credit environment suggests a strong affirmative. Overnight uncollateralised call money rates have increased from around 3.25% in January to around 5.7%, over 250 basis points, much larger than the 75 basis points signalled by the increase in LAF repo rates, partially engineered by a policy tightening of liquidity with the 75 bps increase in the CRR.
Of course, a rebuttal to this reasoning might be that bank lending rates have not responded to the policy rate signals. One reason is that demand for credit has just not been robust enough for banks to start raising term deposits at higher cost and passing on these higher rates to borrowers. Moreover, ample liquidity in previous months had also been a disincentive for increasing deposit rates. This has changed, due to the combination of effects described above. There is little to gain in stressing a fragile credit situation.
We stress again that we are arguing for a pause in the tightening cycle, not an end to the tightening. It appears that we are still some distance from potential output, and the lagged effects of the earlier tightening are only now being felt, probably a little too strongly, given the weak global environment. Rural incomes will certainly revive demand later in the year. As and when credit demand resumes, so must RBI?s calibrated policy tightening.
The author is senior VP, business & economic research, Axis Bank. These are his personal views