The bird’s eye for the central bank in the 27 July review of monetary policy is undoubtedly inflation. This is now posing a serious risk to growth, complexities to which cannot be ignored either. In fact, a broader macroeconomic approach—extending beyond monetary policy—is required to contain inflation and preserve the growth momentum.
The trend in manufacturing inflation—measured as the three-month moving average of the annualized, month-on-month change—is a persistent 9% since April. Emerging capacity constraints in the manufacturing sector suggest that firms’ pricing power is increasing. The direct and the second-round effects of the recent increase in fuel prices will add to this persistence, indicating a generalized inflationary outlook.
The inflation risk is high from other angles, too. If the potential output growth is judged to be 8-8.5% by the Reserve Bank of India (RBI) (it should perhaps take this up as a serious research topic), then the output gap has closed in the January-March quarter. More recent evidence—at least 20% growth in corporate profits in April-June—suggests the gap is now positive. Actual growth, by all accounts, is set to exceed potential output for the year as a whole. Demand-driven inflation is thus expected to pick up markedly in the coming months.
Worryingly, the impact is now evident on both the financial and real sides of the economy.
Deposits have been fleeing to cash balances as falling real returns erode savings. The stock market’s booming and property prices are rocking in some cities. The monetary aggregates show that total deposit growth (year-on-year) slowed to 14% in June vis-a-vis an 18% target. Broad money is well below target, growing slower than base money: The falling multiplier (to 4.8 from 5.2) indicates the shrinking capacity of banks to extend loans. On the demand side, the credit deposit ratio touched 73.3% as non-food credit growth accelerated to 20% in June (year-on-year, deseasonalized); in fact, the sequential, three-month moving average credit growth is a steady 24-25% from January.
The impact on growth is observable in the sharp slowdown in consumer spending, growth in which more than halved to 2.6% in the January-March quarter, compared with the previous two quarters. The 8.6% GDP growth, as a result, was almost exclusively driven by investment expenditure—a highly variable component of aggregate demand. Inflation is now negating the earlier stimulus to growth: It subtracts from the income-sensitive component of aggregate demand as consumers’ purchasing power declines.
Relative to these indicators, the monetary stance is extremely loose, despite the successive upward adjustments in interest rates and the appreciation in the exchange rate (see chart).
So there is little doubt about the need to tighten and align policy rates with both inflation and growth. But investment spending has to be sustained, just as private consumption has to resume for driving growth, since external demand remains weak and uncertain. Therefore, RBI is likely to stick to its calibrated normalization. We can expect a 0.25 percentage point increase in the two policy rates. This however, would indicate a quickening pace of normalization, given that RBI has already hiked rates mid-cycle on 2 July.
Graphic: Ahmed Raza Khan/Mint
Yet, a broader macroeconomic approach to manage domestic demand is called for, despite the pressing case for normalizing interest rates. With a high probability of the downside risks to inflation materializing in the near term, RBI could be forced into steeper adjustments ahead. This would adversely affect investment.
A complementary fiscal response could help avert this possibility and navigate a smoother adjustment. This can be done in various ways. One, the cyclical improvement in tax revenues provides some room for lowering taxes on diesel. This will directly address supply-side inflation by protecting food, input and final product prices from increased transport and distribution costs.
Two, a positive output gap suggests that fiscal policy is now getting pro-cyclical. In line with the new, countercyclical fiscal policy responses that began with the 2008 crisis, a less expansionary stance is needed to address aggregate demand. An improved revenue position—from 3G (third-generation) auction and cyclical upturn—suggests that the actual fiscal deficit will be lower than budgeted. Lowering borrowings, along with a revised deficit target, will translate into a less pro-cyclical fiscal impulse (an impulse measures whether fiscal policy decisions are adding to, or subtracting from, aggregate demand pressures by adjusting for the cyclical impact of revenue). The fiscal response could be phased out; for instance, lowering borrowing needs in the first round, followed by announcement of a revised deficit target after factoring in revenue trends in the second quarter.
Some fiscal adjustment now will enable lesser monetary tightening ahead. It will also reduce the premium investors pay for the sovereign risk on government bonds and therefore, keep long-term interest rates from rising too much due to monetary tightening. Together with the upward adjustments at the short end of the yield curve that the policy normalization will create, the monetary-fiscal coordination will also realign borrowing and lending incentives in the economy.
Interest rates in India are structurally high, partly due to persistent fiscal deficits. And if investment expenditure has to be sustained, keeping real interest rates reasonably low is an essential prerequisite. Monetary policy alone cannot deliver on inflation and growth. India needs the kind of coordinated macroeconomic policies it saw when the crisis began.
Renu Kohli was, until recently, with the International Monetary Fund.
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