RBI is fighting the right battle

Financial Express, 1st September 2012

If cutting rates gives a signal of lack of commitment to controlling inflation, it will do more harm than good

GDP growth at 5.5% for the latest quarter available suggests that the slowdown hitting India is getting well entrenched. For the year 2012-13 as a whole, growth may fall below 6%. This decline in growth has been expected as both investments and exports have slowed down. The uncertainty in the world is not over and it may continue to affect both the investment environment and export growth. Improving the policy environment for investment, controlling the fiscal deficit and reigning in inflationary expectations are essential policy interventions to improve growth.

There are a number of reasons for the decline in GDP growth. Some of these are part of the external environment, while others have been produced by us through a combination of incompetence and politics. Output in advanced economies fell sharply after the 2008 crisis. Many countries have still not recovered to pre-crisis levels of income. Emerging economies saw a decline in growth as well. While in 2010 it appeared as if emerging economies had escaped the worst of the crisis, now it no longer seems to be the case. This gives India an unfavourable external environment. If, with the European market shrinking, China had continued to witness buoyant growth, India could have exported more to China and other Asian economies. But with China seeing its growth decline from above 14% to below 8%, other Asian economies linked to China are also likely to see a decline in growth. Slower growth could also impact world commodity producers who have been witnessing a boom due to China's high demand. If the region does not see high growth rates and does not compensate for the decline in demand originating from Europe, it would mean that exports would continue to be a serious problem.

Second, the biggest driver of growth in India in the last decade was the rise in private corporate investment as a share of GDP. Growth in private corporate investment has declined sharply. The CMIE capex database suggests that after 2008 there has been a fall in investment intentions both by the government and the private sector. Investment intentions picked up somewhat in 2010, but since then have been on a secular decline. The central government failed to announce new projects. This has dampened the environment for private projects as well. A Crisil survey suggests that the difficulties faced by infrastructure projects due to land acquisition, environmental clearances and delays in approvals are critically important in the slowdown. This is where the last three years of inaction and lack of interest in solving the problems of investment is hurting.

What should be done? Industry of course always wants lower interest rates. Even at the peak of India's overheating in the 2006-2007 years, it argued for lower rates. But this time, when the external environment is weak, and when domestic demand has slowed, will cutting interest rates give us high investment and growth in the Indian economy? Today, few suggest that high real interest rates will cure the economy of its problems. But will cutting rates help? Perhaps a little, but this step is fraught with risks and one that RBI appears to be fully aware of. If cutting rates gives a signal of lack of commitment to controlling inflation and prevents inflationary expectations from falling then it will do more harm than good, and is not desirable.

The best measure of inflation is one that hits our pockets, the consumer price index. The CPI Industrial Worker data well represents the consumption basket and has good quality price data used for it. While it may be better to use the new CPI being produced, it cannot be used to track the latest trends in inflation because it will be quite a few years before we have enough observations to do seasonal adjustment of the data. To examine the data, we can think of the CPI as comprising tradables such as consumer goods whose prices are affected by intermediates and exchange rates, and non-tradables such as services. In India, food is non-tradable due to policy.

At present, inflation in food prices has declined on a seasonally-adjusted month-on-month basis (three-month moving average) for the last three months. Similarly, inflation in tradable prices measured by the US PPI multiplied by the rupee-dollar exchange rate has come down a little in the last three months on a month-on-month seasonally-adjusted basis. While inflation based on the CPI has come down, it still remains at higher levels, roughly 12% on a month-on-month seasonally-adjusted basis.

This suggests that out of the three components of inflation in our analysis, data is available for two and it suggests that food inflation and tradables inflation has slowed down. What is left then is the component for which data is not available-services. This must be responsible for the high CPI inflation. Services have a high component of wages and one way to control service price inflation would be to keep inflationary expectations low.

RBI has indicated that inflation should come down to below 5% and stay low before monetary policy easing begins. Such a policy would allow inflationary expectations to come down. To the extent this would affect wages and bring down both core inflation and services inflation, it would help in bringing overall inflation down. RBI's battle today is to bring down inflationary expectations. Higher inflation does not create a conducive environment for growth. The emphasis to push growth and control inflation has to be on controlling the fiscal deficit and improving the policy environment.

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