New challenges for RBI

India right now has one of the highest inflation rates in the world and the Indian central bank seems to be a bit behind the curve at this point of time, despite the fact that it began exiting its monetary stimulus ahead of most other major central banks.

Going by the data published every week in The Economist, only Venezuela among the 42 major economies whose latest consumer price inflation is tracked by the magazine has a more pressing inflation problem than India does.

The median increase in consumer prices in these countries is 2.5%, which is far lower than India’s consumer price inflation for February of 14.8%. The government will on Thursday release the wholesale price inflation numbers for March and it is very likely that the price trend that the Indian central bank tracks most closely will be in the double digits.

The widely accepted view when inflation first gathered speed at the end of 2009 was that higher prices were an unfortunate result of a poor monsoon and monetary policy would be ineffective in controlling it.

Inflation has spread since then and we need more than a good monsoon to keep it under control. Accelerating prices of manufactured goods now account for about half the reported inflation in India, even as there is growing evidence that food prices have also moved up because of structural factors such as higher incomes and cash transfers to the rural poor through the National Rural Employment Guarantee Scheme.

Goldman Sachs economists Tushar Poddar and Pranjul Bhandari said in an 8 April note that there are four reasons why they think inflation will be sticky. One, consumer prices are growing at a far quicker pace than wholesale prices. Two, inflation is no longer restricted to food items; core inflation is also rising as the output gap has closed. Three, commodity prices are putting pressure on headline inflation. Four, inflationary expectations are building up.

India appears to have moved to a new and higher inflation plateau, even if we realistically assume that the headline rate will drop once the base effect kicks in. It is a cause for concern that we see signs of structurally higher inflation at such an early stage of the uptrend in the business cycle. Private investment needs to pick up fast because strong demand growth will soon create capacity constraints in many industries and fan the inflation fire.

I think it is safe to assume right now that RBI will increase both its policy interest rates by 25 basis points on 20 April, as well as increase the cash reserve ratio by the same amount to absorb excess liquidity in the short-term money market, thanks to large capital inflows. The bond markets expect another increase of 100-150 basis points in the repo and reverse repo rates, the two policy rates RBI uses to influence short-term interest rates, this year.

But it is sobering to note that the reverse repo was 275 basis points higher and the repo was 425 basis points higher in October 2008, before RBI slashed rates in a bid to protect the economy from the worst effects of the global financial crisis.

Let us assume for the sake of argument that the Indian central bank was running too tight a monetary policy in October 2008—not a view I subscribe to—then it is not hard to see that interest rates have to move up a fair bit if policy is to get back to neutral mode. The central bank can also switch its strategy and make the repo rather than the reverse repo rate its effective policy rate, which will amount to a further 150 basis points increase in policy rates, assuming the current rate corridor is maintained.

There are valid worries that higher interest rates will harm private sector investment activity in the economy. But the bigger danger here is not the prospect of a move from a loose to a neutral monetary policy, but the huge borrowing that the government plans this year to fund its fiscal deficit.

The narrative here is flawed because of the way the issue has been framed.

Much is being made about the fact that the borrowing programme has been whittled from Rs4 trillion in 2009-10 to Rs3.45 trillion in 2010-11. But remember that the borrowing programme was a mere Rs1.5 trillion two years ago. With private demand for funds expected to pick up and unwinding of market stabilization scheme securities not that easy an option, the impact of fiscal policy on domestic interest rates will be far more serious this year. It is significant that the first government bond auction of the new fiscal year devolved and yields on 10-year bonds in the secondary markets have once again climbed to 8%.

Fiscal policy credibility is a bigger issue than monetary policy credibility at this juncture.

Niranjan Rajadhyaksha is managing editor of Mint. Your comments are welcome at cafeeconomics@livemint.com

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