Real interest rates are the lowest in the last seven years. This is a classical case for central bank intervention to increase interest rates to impart a corrective impulse. But the moot question is: Will the Reserve Bank of India (RBI) go for it at a time when the economy may be poised for a self-sustaining recovery?
In real terms, the policy rates are negative, the 10 year yield is close to zero and lending rates are now 4% (see chart). The cost of borrowing has come down by 50% in the last three months. It is two-and-a-half times below April levels. This came about as inflation shot up to 7.31%—crossing RBI’s year-end forecast of 6.5%, which itself, admittedly, had an upward bias.
While inflationary trends are clear, the picture on growth raises quite a few questions. If gross domestic product (GDP) growth this fiscal is placed between 7.5% and 8%, how much is the slack in output? To what extent was the 7.9% GDP growth during July-September incentive-induced? Is the present interest rate regime appropriate if the potential actual growth gap is closing? Would a modest tightening upset this process? Has the recovery transited to a self-sustaining phase?
Growth trends are mixed. The output-employment-income circle reveals positive trends. Hiring has resumed in information technology services, financial services, power, infrastructure and the consumer goods sectors. This is also accompanied by modest wage increases. Other bright spots include the rise in contribution of sales revenue to corporate profits, levelling of growth across industries, diffusion to the services sector and improved demand conditions abroad. The weak spots are: subdued employment conditions in the manufacturing sector, continued contraction in non-oil imports and declining real credit growth. The contraction in non-oil imports also suggests that private investment activity has not quite picked up. The weak credit growth, ostensibly a sign of concern, is mitigated by buoyant fund-raising from non-bank sources.
Graphic: Yogesh Kumar / Mint
Alongside, growth could be under threat from inflationary pressures that are extending beyond the supply side. It would be useful to recall that in early 2008 it was inflation that caused the sharp contraction in consumption. The public debate on inflation, focused upon supply-side factors, has tended to ignore the fact that core inflation—which excludes food and energy—is strong and persistent. The annualized, three-month moving average of manufacturing inflation is in the range of 4.5-6% since August; year-on-year core inflation rate is rising steadily for the past three months.
Although food prices are the key driver of overall inflation, contributing 3 percentage points, demand pressures are surfacing. Some output prices have started rising as producer margins come under pressure, e.g., cement and steel, with impending price increases in other sectors such as automobiles. On the asset prices front, too, robust demand is driving property prices upwards. Core inflation will gather further momentum in the near-term due to escalating fuel and commodity prices and expected increase in excise duty. The spillover risks thus need to be guarded against, lest inflationary expectations get entrenched.
RBI obviously has to weigh the impact of inflation vis-à-vis monetary tightening upon growth. While the former hits consumption, the latter dampens investment. But ironically, long-term interest rates have risen by a full 2 percentage points in the year to January 2010, despite the extraordinary monetary loosening that should, ideally, have led to a decline in interest rates. This is the zone for reconciling the inflation-growth trade-off for eventually the fiscal position and inflation will thwart the economic recovery. A concerted monetary fiscal effort is needed to bring down the long-term government bond yields.
With real yields hovering at zero and borrowing costs falling dramatically, nominal bond yields will climb further, with or without monetary tightening. In December, the term differential widened to 425 basis points, as inflationary risks added to the fiscal worries embedded in the long-term yields. In January, the spread has widened by a further 10 basis points.
The price stabilization objective will gain weight in RBI’s reaction function as the negative real policy rate challenges its credibility. Left to itself, RBI would want to align interest rates to stay with the curve, if not ahead of it, as a forward-looking central bank would. But monetary policy in the real world is hardly shaped by monetary factors alone. New Delhi seems hesitant to disturb the present interest rate regime.
Which foot will RBI extend forward—adjusting liquidity or raising interest rates? Given the responses of different stakeholders, the central bank may well be inclined to adopt a wait-and-watch mode, ride the food prices’ hump and allow fiscal measures to affect supplies. It may restrict itself to raising the cash reserve requirements to the extent that the markets are prepared for. Alongside, one can expect tough speak on demand-side inflation and the need for fiscal reparation to bring down long-term interest rates.
Renu Kohli was, until recently, with the International Monetary Fund. Comments are welcome at email@example.com