Why RBI Should Be on Hold
Indian monthly inflation number for August was released today and it showed a minor uptick. There is a possibility that this will goad India’s central bank, the RBI (Reserve Bank of India) to continue with its hawkish stance, irrespective of the disastrous IP number released earlier this week. The feeling is that, the IP number being highly volatile, RBI does not focus as much on the same. Hence, the uptick in monthly inflation is what will matter.
Question is, is that a fair argument? I do not think so. Neither possibly does Anirvan Bannerjee of ECRI. In his interview given to one of India’s leading business newspapers the Economic Times (http://articles.economictimes.indiatimes.com/2011-09-12/news/30145180_1_recession-threat-geoffrey-h-moore-anirvan-banerji), who mentioned that most of the central banks, including RBI, do not have a leading indicator to follow and hence they continue with their policy action even when they should ideally have stopped either way.
I do agree with him. I am sure inflation has peaked in India and it is only a matter of a few months before the real moderation begins, irrespective of whether further tightening takes place or not. On the other hand, there is clear visibility of demand destruction in India.
While last year RBI erred on the side of caution (more concerned about growth than inflation, what with their utter failure to gauge the extent of inflationary pressure that was building up), this time around the RBI is likely to err on the side of being excessively vigilant and is willing to sacrifice growth to control inflation.
The problem is growth is slowing. Further tightening will only exacerbate the problem as inflation has peaked in India.
Source: Office of the Economic Advisor, GoI
The sharp fall in India’s WPI inflation, post the emergence of crisis was followed by an equally sharp uptick. As the chart above shows, inflation in India has peaked out, save for minor fluctuations. During 18 out of the previous 19 months, India’s inflation ruled at or above 9% and the base effect will ensure slow moderation of inflation.
More importantly, however, there is clear evidence that monetary tightening is having its impact on credit growth and demand.
Source: RBI
Interestingly, the RBI has started the rate hike cycle by the time the IIP growth has virtually peaked out. While the IP numbers are notoriously volatile, the downward movement is still clear even if we smoothen it out by using the three month moving average (3MMA) data.
Source: RBI
The fact is the initial calibrated approach of RBI in its monetary policy stance, given its highly optimistic inflationary expectations and the fear of growth slowdown (in case of tighter monetary policy) as the economy recovered from slow growth clearly failed to tamper inflationary expectations. With the banks responding to the rate hike with a lag of 5 to 6 months meant that there was enough front loading of demand, given substantial availability of liquidity and high negative real interest rates, which would have shaved off a few basis points from the future growth.
The problem was exacerbated by the persistently high food inflation as the structural deficiencies of the economy came to the fore. Between June 2009 and April 2011, monthly food inflation remained at or above 10% y/y, with seven continuous months of 20% plus inflation rate. This fed into inflation through the wage price spiral. In addition, high global commodity prices manifested itself in the form of higher inflation through the trade channel.
However, at this point in time, RBI is wrongly focussed on manufacturing inflation. Gently rising manufacturing inflation is being sought to be explained as increasing pricing power of the producers and hence RBI continues to make hawkish noise. However, it is important to note that the manufacturers are only partially being able to pass on the input cost hike for fear of losing demand.
Source: Office of the Economic Advisor, GoI
The high interest rate, in the vicinity of 18% for the SMEs are being dealt with a triple whammy – falling demand, rising input cost and very high interest rate. In my previous post (http://www.economonitor.com/analysts/2011/08/31/indias-manufacturing-sector-feeling-the-heat/) I have discussed these issues in detail. Fact is, SMEs are the backbone of the economy and they generate the maximum employment in India. Hence, if their health is at risk, the employment situation will worsen, as units start to close down. I would also like to point out the recently released Manpower quarterly hiring survey, wherein India’s hiring outlook fell steeply from the third quarter, although the overall outlook is still better than many countries.
Bottom-line – inflation has peaked in India and further monetary tightening can only harm the economy from here onward.
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