The inflation number on Friday was a wake-up call to the market. So far, it hasn’t really sunk in that the cycle has turned and that, going by past experience, it might take years before the market regains the heights seen in January.
Analysts continue to flog stocks, technicians talk glibly of support levels and while it may not be business as usual, the mood has been of a pause, a hiatus before we see sunny times again.
The surprise is that this attitude has been maintained in the face of a global credit crisis, unprecedented oil prices, immense political uncertainty, fund outflows, rising interest rates and slowing growth. Friday’s sell-off has finally destroyed those illusions.
The last time wholesale price inflation had risen beyond 10% was in 1994 and 1995. However, inflation at that time was caused not by supply pressures, but by high fiscal deficits on the one hand and high money supply growth on the other, the latter being the result of rapid growth in foreign inflows.
This time, while expansionary fiscal and monetary policies have added fuel to the fire (and this column had shown how money supply growth had been much in excess of nominal gross domestic product growth in the last few years), inflation is also the result of supply-side factors, which makes managing it much more difficult.
In the present circumstances, the Reserve Bank of India (RBI) has no choice, but to tighten further. There’s quite a bit of anecdotal evidence suggesting that the slowdown is the result of the economy bumping up against the limits of its absorptive capacity.
Reports are coming in of capacity bottlenecks, with analysts pointing out that while companies have been increasing capacity, their vendors have not. Others point to the lack of skilled labour, with even civil construction work being delayed because it’s difficult to get workers.
These are all signs of the beginning of a downturn in the business cycle. The 71% rise in direct tax collections in April-May, especially the 68% rise in corporate taxes, is yet another indication that growth will have to slow considerably before it has any appreciable impact on inflation.
Gaurav Kapur, senior economist at ABN Amro Bank NV, emphasizes that in this environment, RBI has to act swiftly and very sharply to dampen inflationary expectations, perhaps by a rate hike now and another one in July.
The other point is that any tightening of monetary policy by RBI now will take effect only with a lag of at least a year, which means that its impact on the economy will be felt only next year.
Add to that, the legacy of a yawning fiscal gap and price controls that a new government will inherit next year and it’s becoming increasingly clear that 2009 is going to be a difficult year as well. The market is beginning to price that in.