Shield the economic recovery

An economic recovery is well under way in India. However, managing this recovery is turning out to be as daunting for the Reserve Bank of India (RBI) as was battling the preceding crisis. In some ways, the policy choices might have become even more complex now because the days of uninterrupted monetary stimulus are over and policymakers are confronted with quite a few textbook dilemmas.

Industrial performance over the last few months has been nothing short of spectacular. However, inflation is turning out to be persistent, pervasive and painful. Remember, inflation was a negative one per cent (prices were declining!) just a year back and now it is comfortably breaching the double-digit mark.

To put this into perspective, the last time when inflation stayed above 10 per cent for five consecutive months (between June and October 2008), the economy was reeling under a global commodity price shock with oil prices at $150 per barrel. Clearly, that has not been the case this time.

This inflationary episode is rooted in food prices and the first line of defence was from the fiscal side with a plethora of measures announced in late 2009 and early 2010. Monetary policy was kept on hold because it was mostly ineffective in addressing supply side issues.

But non-food, non-fuel core inflation has shot up from 1.5 per cent in December to more than nine per cent now, clearly indicating that demand side factors are stoking inflation. Capacity constraints are emerging in some industries, pricing power is returning and recovering labour markets might have been pushing wages higher.

More importantly, price pressures are not isolated to a few sectors but spreading fast. Clearly, the circumstances necessitate monetary policy action, but the pace at which RBI should move remains a debatable proposition. To my mind, if India has to achieve its aspiration of nine per cent GDP growth, then the support from a benign interest rate environment becomes crucial.

The astronomical industrial growth rates are likely to moderate as witnessed in the Index of Industrial Production data for May (11.5 per cent from 16.5 per cent in April). Private consumption growth still remains weak in the official releases and the growth momentum is carried forward only by a recovery in capital expenditure. Any spike in borrowing costs, then, is fraught with the risk of stunting investment growth. More so, given the uncertainty over the global growth outlook, exports are unlikely to provide much support to the growth momentum.

Let's consider inflation. With the recent fuel price hike, the direct and indirect effects are likely to keep headline inflation elevated in the near term, but it should start moderating substantially from the last quarter of 2010 as the base effect kicks in. So price increases this year are likely to be much smaller than the huge increases earlier.

RBI has actually been criticised for falling 'behind the curve' as real interest rates (the real cost of funds to the borrower, removing the effects of inflation) are still negative. This is potentially damaging for the economy as it discourages savings, in turn constraining the availability of funds in the banking system.

But one must appreciate that part of the normalisation in real interest rates is likely to happen because of an expected fall in inflation. So, a substantial hike in interest rates might not be needed to correct that. But the RBI will need to stick to a hawkish rhetoric to ensure that inflation expectations and inflation acceptance remain under check.

We feel that baby steps along with a tough rhetoric are what the RBI will opt for. If the rain gods do not disappoint, then inflation should come down to around 6-6.5 per cent by the end of the fiscal year, and India could look forward to a Goldilocks combination of high growth and low inflation.

— The author is an economist and Regional Head of Research, Standard Chartered Bank