Monetary policy: doing nothing is a greater risk

After the May Wholesale Price Index (WPI) numbers, should the Reserve Bank of India (RBI) cut rates and/or reduce the cash reserve ratio (CRR)? That may be the wrong question to ask. If the economy is going down the drain, then core inflation is going to come down. If demand is badly hit, firms will be unable to pass on increases in costs and core inflation will decelerate.

That is what happened when demand collapsed during the Lehman Brothers crisis. In September 2008, wholesale price inflation was at 10.8%. In October 2008, when RBI started to cut rates, WPI was at 10.7%. In November, it fell to 8.6%. Thereafter, WPI moved down rapidly: 6.7% in December 2008; 5.9% in January 2009, 3.6% in February and further down in subsequent months.

But we’re not in Lehman 2.0, although the crisis in Europe could lead us there. One big reason for the swift fall in inflation post-Lehman was the plunge in commodity prices, as the world economy contracted in 2009. This time, although commodity prices have turned soft, global growth is in positive territory. When domestic demand is weak but commodity prices are high, the pressure will be on the margins of firms.

The question then is: is the economy really in the dire straits portrayed by the Index of Industrial Production (IIP) and gross domestic product (GDP) data? If it is, then RBI should cut rates. The average of the composite Purchasing Managers’ Indices for March, April and May is lower than the average for the preceding three months, indicating a deceleration in growth. The Purchasing Managers’ Index (PMI) data on output prices suggests firms still have pricing power, although they are unable to pass on the entire rise in input costs and margins are under pressure.

Emkay Global Financial Services Ltd has analysed the March quarter corporate results and found that: “The broader level stress is reflected in the numbers for BSE-500 (ex-Nifty, non-bank and oil companies) where the sales growth decelerated to 12% year-on-year (y-o-y) (averaged 21% for the past four quarters) and APAT (adjusted profits after tax) contracted 28.2% y-o-y (-17.3% in Q3FY12 and 10.5% for the past four quarters).” Decelerating sales growth is an indication of slowing demand and eroding pricing power.

There is also little in the outlook to suggest optimism. Banks’ credit-deposit ratio continues to be high, affecting their ability to lower interest rates. Exports have been falling. The situation in the euro zone remains uncertain. Job losses have started. Given the circumstances, for RBI to do nothing will be a greater risk for the economy than easing policy.

The RBI governor has said that some amount of growth must be sacrificed to bring down inflation. The question is, how much growth? If the trend rate of growth is higher than what the latest GDP and IIP figures suggest—and RBI has said it is—then it’s time for monetary stimulus. And since rate cuts won’t work unless there’s adequate liquidity, it’s time to cut CRR.

manas.c@livemint.com