Headline inflation has been in the double digits since February. But we have been in collective denial that this has anything to do with demand pressures. Rather, the entire blame has been foisted on last year’s weak monsoon. This may have been true in December, but not in July. Instead, the unabated rise in non-food inflation is now threatening to turn rabid. So it was a relief to read the Reserve Bank of India (RBI) explicitly stating in Tuesday’s policy review that inflation now is the dominant concern.
To be fair, RBI has been warning us for some time that the inflation pressures should not be taken lightly. But its actions did not reflect either the urgency or the extent of the problem till now. Not that Tuesday’s 25 basis points (bps) hike in the repo rate was the magic bullet. Even with this rate hike, the repo rate stands at 5.75%. RBI’s revised estimate for end-March inflation is 6%, such that the expected real repo rate is still negative and the gap with RBI’s revised projected growth rate is 875 bps.
The importance of the policy statement was not just because the gap between where rates are and where they should be was narrowed. What stood out was that RBI for the first time in this cycle explicitly stated that it would make certain that market rates remained high. This it did in three ways. First, it raised the reverse repo rate by 50 bps and not just 25 bps, such that even if the current liquidity squeeze reverses temporarily, overnight rates will fall less as the bottom of the policy corridor has been raised. Second, the central bank made it clear that it likes the system to be starved of liquidity as lending rates then respond more quickly to policy rates than when liquidity is ample. So even if bank liquidity turns to surplus, RBI will likely raise the cash reserve ratio to push the system back into deficit. Third, RBI announced that it would review its policy every 45 days and not 90 days as is the case at present.
Some may argue that all this is overkill. Growth still faces headwinds from an uncertain global environment and credit has not really picked up. True. But think of the alternative, i.e., not doing anything. In contrast to popular belief, food inflation was last around 5% in mid-2007. Instead, it had risen relentlessly to 12% even before we learnt that monsoons last year would be weak. And this rise in food inflation was because demand has consistently outstripped agricultural supply. This is a good thing as it shows rather dramatically that some of the 9% growth in India has trickled down. But for food inflation to come down, it will take a substantial increase in agricultural productivity, not fleeting base effects on which we appear to be placing our faith. On the other hand, manufacturing inflation is threatening to break into double digits soon. This is to be expected too. After surging at 15% for the last six months, the industrial sector is seriously capacity constrained too. The expected rebound in private investment will ease this, but it will take another 9-12 months for the investment to turn into capacity. And so for the next 12-18 months, if India grows at 8-9%, inflation will be high and sticky. Leave these inflationary pressures unattended and they will soon turn into concerns of hard landing, drive away investment, and make the very 8-9% growth rate look like a distant dream.
Jahangir Aziz is India chief economist, JPMorgan Chase. The views expressed here are his own.
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