The Reserve Bank of India (RBI) has correctly raised interest rates and pre-emptively tightened lending norms for real estate. It has put the likelihood of further rate action in the immediate future as being relatively low.
The key question is: what will be the monetary stance beyond the immediate? The extensive and clear analysis provided in the policy statement suggests that any pause in the rate hiking cycle may be short.
Policy rates are now at neutral, but there is a strong case for the monetary stance to be tight, as RBI has so cogently laid out.
First, rising asset prices. Property prices have risen by over 30% in Mumbai over the past 12 months, and by an equivalent amount in Delhi-Gurgaon since the start of 2010. Although the tightening of lending norms may take some steam off, expectations are building up for further property price increases, and speculative activity is rising. These are buttressed by significant increases in equity and gold prices.
Further, capital inflows due to near certain quantitative easing in developed markets can exacerbate upward pressure on asset prices.
Second, the twin fiscal and current account deficits. India’s current account deficit this year, in all likelihood, may be the largest since the 1980s, even larger than the crisis year of 1990-91. Such a high deficit threatens macro stability and is, at least in part, a symptom of overheating. To restore external balance, there is a need to moderate buoyant domestic demand and the trade deficit, and even though fiscal policy is best placed, there is a role for monetary policy to be tight.
Third, financial conditions are still not tight. The rising stock market has largely offset the increase in effective policy rates. Therefore, financial conditions still need to be tightened to control inflation.
Fourth, commodity prices are on the rise. The surfeit of global liquidity may exacerbate these pressures, and can potentially worsen India’s inflation, current account and fiscal deficits. In this situation, the appropriate policy response is to keep monetary policy tight.
Finally, it is difficult to see headline inflation coming down to 5.5% by March 2011. Given the analysis RBI has provided of the structural drivers of food inflation and the persistently high level of inflation despite the favourable monsoon, rising asset and commodity prices, and elevated inflationary expectations, inflation will likely remain above RBI’s comfort zone. Just as inflation expectations go up gradually, they can only come down gradually. Not only does the level of inflation remain stubbornly high, there is also significant uncertainty about its future path, which can distort economic decision making.
India is in danger of a boom-bust cycle typical of emerging market crises in the 1980s and 1990s characterized by high twin deficits, high government debt, large short-term capital inflows and unsustainable asset-price increases.
To prevent this from happening, future policy would need to be tight. Fiscal policy is best placed, but monetary policy also has to bear its share of the burden.
Therefore, it will be important to maintain the policy stance, and keep any pause in rate hikes, short.
Tushar Poddar is vice-president, Asia Economic Research, Goldman Sachs.
These are the author’s personal views.
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