The half-yearly review of monetary policy by RBI (forthcoming on October 27) will be done in a remarkably complex economic and financial matrix. Much more than in other reviews, growth outcomes will be much more dependent on the call that RBI takes on economic risks building in the country. Tighten too soon and risk a relapse of low growth; hold off long enough and set off a wage price spiral. Two issues become important in this decision. One, what is timing the tradeoff between growth and suppressing inflation and second, what is the optimal phasing of monetary tightening?
A cluster of economic indicators suggest that economic recovery in India has been more marked than we had earlier expected. The data on industrial activity just released shows that August 2009 growth of the Index of Industrial Production (IIP) was 10.4%, with the manufacturing component at 10.2%. Global trade news has also been encouraging. In line with the improvement in India?s September exports, some other Asian economies have also reported higher exports, lending credence to an improvement in global trade. However, significant weaknesses remain endemic. A mainstay of credit lines, bank lending remains relatively subdued, despite some signs of demand pickup over the past couple of fortnights.
At the same time, some asset markets, particularly equities and gold, have virtually doubled over the past six months, reaching valuations that are difficult to justify at current levels of economic prospects.
Price inflation has become a significant concern, both in its trajectory and the expectations that it generates. Although the WPI inflation measure had remained negative, that was just a statistical artifact of the way the measure is calculated. Price pressures of foodgrains, fruits, vegetables and sugar have remained persistent, aggravated by the rainfall deficiency this season. Street estimates of WPI inflation are converging towards 7-8% by end-March 2010, but the dynamics of inflation in India suggest that the trajectory will then start falling well into 2010.
Much more insidious, and of more concern to RBI, are the expectations that this increase is likely to generate. Thus far, inflation has remained confined largely to primary commodities; so called ?core? inflation has remained moderate. There are legitimate fears that with global recovery gaining momentum, industrial commodities and inputs will begin to harden, with price pressures then diffusing to broader components.
At the same time, the threat of this price inflation escalating to a wage-price spiral, which is the real danger of inflation expectations, must increasingly be gaining ground. Although prospects of wage increases remain muted, since demand conditions are still sufficiently weak to prevent a rapid wage escalation, the fact that the Dearness Allowances of a significantly large number of government employees remain indexed to CPI inflation would lead to automatic escalations in their salaries. But wage concerns probably still remain secondary. In India, inflation expectations get engendered more through bond markets than wages, and bond markets are clearly bearish. Yields on the benchmark 10-year sovereign paper have remained persistently high, and have jumped after signals from RBI that India might have to start tightening much before developed markets. It remains unclear how much of this bearishness arises from inflation concerns and how much from possible rate increases. After all, the inflation trajectory shown in the chart has been common knowledge for some time.
Moreover, this picture is likely to get complicated if the rupee begins to appreciate significantly, due to increasing capital inflows and particularly so if RBI were to tighten monetary policy. The immediate adverse impact will be on exports, which are already operating in weak global demand conditions. The rupee has appreciated more than the currencies of India?s South Asian export competitors and those of some other emerging markets. RBI might judge that the positive effects of a stronger rupee, particularly in weakening imported inflation, might actually reinforce the fight against inflation expectations. Particularly so if the negative consequences of domestic liquidity creation following RBI currency intervention are avoided.
This brings us to the question of increased liquidity. Although systemic liquidity, measured by broad money metrics, remains more or less on trend (with lower bank credit offsetting increased credit to the government), banking sector liquidity remains high and will probably persist for some time. How much of this liquidity is contributing to the current inflation remains unclear, but at the margin, it must surely be. The sharp jump in LAF balance that seems to have been parked with RBI today has again raised the possibility that RBI might act to compress.
How then might RBI assess the utility of alternative tightening measures?
(To be concluded)
The author is vice-president, business and economic research, Axis Bank. He acknowledges the contribution of colleagues. Views are personal