In the run-up to RBI?s mid-quarter review of monetary policy in mid-September, various trade-offs have crystallised and sharpened. That growth has slowed and demand is weak (except in fragmented pockets) is now taken for granted, although there is still some ambiguity about what this says about India?s potential growth. That inflation is trending down, the momentum of price increases slowing, is also now taken for granted. In fact, a deputy governor of RBI is believed to have said that macro-prudential measures to mitigate an emerging risk of banking stress and financial stability would need monetary policy support.
In this context, two distinct but inter-related issues have come up to the front. One, what is the nature of inflation, its trajectory and inflationary expectations? Two, suppose it is accepted that inflation is coming down to more acceptable and sustainable levels, and growth needs to be enabled through monetary policy, what is the most effective means of doing this?
The key question is the extent to which inflationary pressures are moderating and their likely trajectory over the next couple of years. Despite having dropped from double-digit levels of 2011, inflationary pressures still remain embedded in the system, persisting at 7% level. This conundrum (persisting inflation despite slower growth) was highlighted once again in the last set of Purchasing Managers Index (PMI) data, for August (see Chart 1).
Even as input and output prices seem to have mostly held up, the terms of trade (i.e., pricing power, defined as the ratio of output to input prices) have improved, indicating that producers have mostly been able to pass on higher input costs (see Chart 2). This trend is also buttressed by the last round of RBI?s Industrial Outlook Survey, with a higher and steady number of respondents indicated that selling prices were likely to increase in Q2 of this fiscal.
These trends indicate that pricing power (and hence demand) is still holding. However, these charts don?t square with trends seen in the results declared by companies in the first quarter of FY13. Chart 3 indicates the squeezed margins of a sample of 1,400 manufacturing companies (excluding oil and gas). This could not have happened if companies were able to pass on rising input costs.
One possible resolution of this conundrum is that while announced retail prices (MRPs) have held up, producers and sellers have been forced to offer significant discounts, which have dented their margins and profitability.
If one assumes that demand is in fact weakening, and monetary policy easing will need to be deployed in the absence of accommodation from other policy quarters, and that this will help in boosting sentiment and then more gradually in economic growth (which we think it will), what might be the optimum way to do this? Obviously, through a combination of rate cuts and liquidity infusion. RBI has already emphasised that it will provide sufficient liquidity in the system, so that call and short-term rates will not deviate significantly from the policy rate. A rate cut, in these conditions will bring at least the shorter end of the yield curve in line with the policy rate. The reluctance of banks to lower the base rate presumably stems from concerns of deteriorating liquidity going forward and consequently higher cost of funds; these concerns will likely be mitigated with the combined approach (as well as other measures, some macro-prudential, like the unexpected reduction in the SLR in July).
As a coda to this article, we must point out a disturbing aspect of bank credit allocation, which a new data release has unearthed. In the four months of FY13 (till end-July), overall credit has not fallen all that much compared to the same period of FY12. However, credit flow to industry has plummeted from R59,000 crore April-July 2011 to a mere R2,000 crore this year. At the same time, personal loans (including housing loans) have gone up from R13,000 crore to R37,000 crore, most of this emanating from ?other personal loans?. A new front on credit stress might open up if the growth slowdown continues.
The author is senior vice-president, business and economic research, Axis Bank. Views are personal
