The objective of monetary policy is to meet the twin thresholds of inflation and growth. Several studies in the Indian context have indicated that beyond 5-7%, inflation measured in terms of the wholesale price index will impinge on growth. Data on the growth of the GDP and implicit GDP deflator clearly indicate that the moderation in inflation in the last 16 quarters has resulted in a greater sacrifice in terms of growth (figure 1). For over 12 quarters, the observed GDP growth has also been lower than the potential growth.
Implicit GDP deflators are available only on a quarterly basis and have a considerable time lag. In view of this, RBI now looks at the consumer price index (CPI-new series) as the inflation anchor which closely reflects the cost of living and influences inflation expectations relative to other available metrics. Food inflation from November 2013 to October 2014 has declined by 900 basis points, from 14.7% to 5.7% (figure 2).
Non-food inflation, which has been a little stickier, hovering between 7% and 9% during April 2012 to June 2014, has also moderated to 5.3% in October 2014. Further, while there could be a moderate upswing in food inflation (as reflected in a decline in index in December 2013 and January-February 2014 and erosion of base advantages), non-food inflation may not experience any such eventuality. Moderation in non-food inflation is likely to continue.
Corporates have less pricing power now. Corporate margins, which are a better proxy for corporate pricing power, have witnessed a secular squeeze from 11% in 2007-08 to 5.8% in 2013-14. Only large-sized companies maintained positive net profit margins in the last two years, while the small- and medium-sized companies incurred losses.
Erosion in competitiveness has affected industrial growth. Contribution of industries has also declined from 38% in Q4 of 2009-10 to negative in Q4 of 2013-14. With IIP growth in Q2 of 2014-15 currently estimated at 1.1%, industrial growth will remain subdued.
The rupee has remained fairly stable. This apparent stability of nominal exchange has concealed the appreciation in terms of the real effective exchange rate (REER). Though global economic growth has been an important factor, export growth of merchandise goods in recent months also appear correlated with inverse of REER (currencies trade based weights with 2004-05 as base), suggesting that a stable and depreciated REER may be desirable for both merchandise and service exports.
In contrast to the domestic inflation, the global economy is currently characterised by benign price regime. Crude oil is not expected to reach levels beyond $85 in the foreseeable future. Corn prices have declined by over 15% this year, iron-ore by 40%, cotton by more than 25%, copper by more than 9% and thermal coal by over 20% with less probability of going up in the near future.
There exists a view that lowering interest rates may create some problems for financing CAD. In fact, CAD is expected to be less than 2% of GDP this fiscal, despite some increase in gold imports in October 2014. Though exports to Europe are not expected to grow, at least exports to the US, the UAE and ASEAN may show an increase, provided there is no erosion in our competitiveness relative to their other competing trade partners. The PMI on export orders point to a secular increase in the index in the past few months. Further, our total debt and equity flows this year are a record, at $39 billion, higher than full year inflows of $31 billion in calendar year 2012. With an improving US economy attracting investment and possible interest rate increase next year by the Fed, problems of outflow could be an issue with RBI, but with reserves built-up already and QEs by European Central Bank and Bank of Japan, we may not face a problem as we faced in 2013.
There has been a view that with ample liquidity in the system, banks are reducing both deposit and lending rates; why should then one bother about repo rates. There are undoubtedly transmission lags in monetary policy as are recognised leakages. Yet normal monetary policy operates on the principle that there is a “market clearing” interest rate (or a set of market rates) that balances desired savings and desired borrowings and prevents resources from remaining unutilised. The central bank’s normal goal, then, is to adjust its policy rate to nudge market rates towards that market-clearing level. Further, if rates are also moderating, is it not proper to recognise it upfront?
Another view is that lowering rates now will increase asset prices, especially as it would come on top of copious inflows; such an increase in asset prices is not warranted by fundamentals. The inflows are, in any case, neutralised to a large extent by open market operations (OMO) in forward dollar market by RBI. There will be competing demand for resources for investment with the government exhibiting its intent and committing through action to enable manufacturing to take off in a big way. Already, total credit in the private non-financial sector has dropped down to 50% of GDP and there will be a demand for investment when realisation dawns that rates will go southward with inflation coming down.
Anchoring market expectation around GDP and its growth helps better manage supply shocks. It implies a more accommodative policy, when the economy is being hit by a negative supply and inflation near or even below its threshold level or the point of influx. While the government is making efforts in creating expectations, fast-tracking implementation of projects, reducing regulatory hurdles and fiscal consolidation, the monetary policy stance need to change to signal growth back on its radar. Synchronisation of fiscal policy, particularly with regard to the quality of fiscal consolidation (achieved through a reduction of non-plan expenditure and improving expenditure in infrastructure), keeping the increase in the minimum support prices to reasonable levels warranted by cost increases only, and an increased investment activity through its parastatals should bring back the growth momentum.
By R Gopalan & MC Singhi
R Gopalan is former secretary, Department of Economic Affairs.
MC Singhi is former senior adviser in the ministry of finance