The economy is slowing on many fronts. Industrial production, car sales, Purchasing Managers’ Index—all point to activity moderating. On cue, there has been a lot of hand wringing over this. But a slowing economy is not necessarily a bad thing. Indeed, the real risk is the economy will not slow sufficiently to bring down the raging inflation.
Consider the following: Back in January 2010, headline inflation was 8.7%. Food inflation was at a scary 19.8% and core inflation a benign 3.7%. Between then and now, there were 10 interest rate hikes and two bumper harvests. But all that changed was that headline inflation rose to 9.4% (in reality over 10%, given the now-customary 0.8 to 1% upward revision) and non-food manufacturing inflation or core inflation replaced food as the main driver of inflation.
With core inflation at 9% and threatening to rage on there, the best way to bring it down in a hurry could be slowing growth. Core inflation is rising because producers have sufficient pricing power to pass cost increases to consumers—a tell-tale sign that demand remains strong. Boosting investment to expand capacity and release the pressure on prices is clearly needed, but it is a medium-term solution.
When food inflation is tolerated for too long, as was done in India, it hardens inflationary expectations that eventually spark a generalized inflation. This happens in every economy. And India has not been the exception we tried so hard to believe would be true.
So like other countries, India too will need to slow growth further if it intends to avoid a hard landing. In the last six months the Reserve Bank of India’s (RBI) survey of inflation expectations has moved relentlessly upwards despite the 10 rate hikes, underscoring its ugly nature. Once the expectations genie is out of the bottle, it is very difficult to contain it without audacious policy changes.
Inflation today is poised to rise well into the double digits. Unlike in 2008, when luck (the global financial crisis) more than anything else, brought an end to the runaway inflation, this time around it looks unlikely that the global economy will slow sufficiently to bring down the pace of price rise. Surging export and non-oil import growth suggest that the global economy has not lost as much zing as feared and that private investment in India may soon start adding to domestic demand.
Last May RBI shrugged off its institutional inertia to raise rates 50 basis points (bps). One basis point is one-hundredth of a percentage point.
Till then, its 25 bps rate hikes relied more on hope than design to tame inflation. Importantly, it also acknowledged that inflation was demand-driven and expectations were coming unhinged. Those were the clearest signals yet that RBI was not afraid to turn on the heat when needed.
Next week it needs to move more audaciously. Market pressure will be against RBI to hike rates on fears of slowing activity further. But hopefully, RBI will see the writing on the wall that another 25 bps hike just won’t be enough and raise rates more aggressively.
Jahangir Aziz is senior Asia economist, JPMorgan Chase. These are his personal views
On 26 July the Reserve Bank of India will announce its quarterly review of monetary policy. Will it continue to tighten the policy with yet another rate hike to fight high inflation or will it press the pause button as growth is being threatened? This is first of a series that Mint will carry over this week in the run up to the policy.