Not for the 9th time: Financial Express: 29th April 2011

Ever since we embarked on the path of fine tuning monetary policy last year, meaning eight such announcements, a lot has been said every time about what RBI should or should not do. Fiscal year 2011 was quite unique in the sense that it has thrown up a lot of surprises. Inflation has been an enigma that we just could not understand and several theories that popped up did not stand the test of time. We spoke of food

inflation but agricultural production has reached a peak this year. We are now talking of core inflation rising, i.e., non-food and -fuel inflation. But aren’t commodity prices, such as those of metals, moving up increasing the prices of manufactured goods? And if core inflation is the issue, then we should be seeing excess demand forces somewhere. But, is this visible?

This is critical because the policy to be announced on May 3, 2011, is for the year, and RBI will be giving direction on both GDP and inflation targets. While these are not sacrosanct numbers, they would indicate to a large extent the course of likely action by RBI during the year, which is more important. An inflation target of, say, 5%, which has been the convention so far, will mean that RBI will keep increasing interest rates until such time that the number comes down to this level. On the other hand, if it is in the region of 6-7%, then maybe we can expect a pause as the present inflation number will come down gradually.

The other issue is, of course, GDP growth. Normally, the targeted range has been between 8-9% and given that the Planning Commission is looking at higher numbers from FY13

onwards, RBI will have to strike a balance between such optimism and the pessimistic numbers rolled out by private agencies, which are looking at the range of 7-8%.

Therefore, the announcements made in this credit policy will be crucial as it will once again be all about interest rates. RBI has increased rates eight times since last March but the impact on inflation has been limited (Chart 1). The prices of primary products have shown an uneven trend, while those of manufactured goods have increased in the last few months. Higher interest rates have certainly maintained the level of ‘real interest rates’ and protected deposit holders and other returns on debt instruments quite well. The question is whether we have reached an inflection point after which further rate hikes will impede growth. This is pertinent because if increasing interest rates has not helped to temper inflation, are we chasing the incorrect shadow?

There are already signs that investment decisions may be getting deferred today in the current environment. This holds especially for capital intensive and infrastructure projects where funds will be locked in at higher rates of, say, 13-15% for an extended period of time. The internal rate of return so

calculated may not justify these high borrowing rates. The SME segment, which may be confronting even higher rates, may not find it feasible to expand further at this stage. Chart 2 shows that in the last three years, there are signs of the rate of fixed capital formation coming down, which is certainly not good news for growth prospects.

So what should RBI be looking at? As the controller of monetary policy, RBI has to choose between the Keynesian and Monetarist hats. Chart 3 juxtaposes growth in GDP with bank credit and money supply. Growth in money supply has been lower this year while growth in credit has been commensurate with higher GDP growth, which is still lower than that in FY07 and FY08. Clearly, growth in credit (which will be lower if an adjustment is made for the R1 lakh crore outflows on account of 3G auctions that have been locked with the government during FY11) has not shown signs of going overboard. If we are looking to control inflation, then the question is whether there are demand pull inflationary forces in the economy that can support the argument.

Looking at the GDP numbers of the CSO, we see that there are three elements there. Consumption growth has been steady, with the higher value of consumption being more on account of protecting existing consumption. Chart 4 shows that consumption as a proportion of GDP has actually been coming down over the years. Therefore, it cannot be argued that households are borrowing money to meet their growing consumption requirements. The second element, capital formation, as mentioned earlier, has shown signs of slippage and will be on the radar of RBI.

The third important element is growth in government expenditure which is captured by the community,

social and personal services in the GDP numbers. The quarterly growth numbers provided by the CSO, again, show a continued slowdown in this number. This was a conscious act of the government to roll back on the fiscal stimulus (Chart 5).

Therefore, there are two fairly unequivocal observations that stand out. The first is that interest rate hikes have not really had an impact on inflation, with the prices of primary products showing double digit growth. The second is that there is reason to believe that growth can slow down in case there is further monetary policy action. Therefore, a modified Keynesian approach of deferring a rate hike and, hence, taking a pause can be argued for under these circumstances.