Monetary policy in India has had to contend with elevated inflation and a deteriorating fiscal picture. In a welcome move, the central bank hiked rates and refrained from basing monetary policy on the conventional wisdom that slower global growth will eventually lower inflation. The recent policy moves should aid the process of bringing down inflation to a realistic level of 7% from current double digits.
International crude prices are expected to remain high in view of the tight demand-supply balance. EIA expects crude oil price to average $127 a barrel in 2008. Recently, oil prices have come off from the peaks seen earlier in the month. This seems to be a correction rather than a trend reversal. Current energy prices reflect a demand shock from emerging markets economies. This is quite unlike the oil shock of the 1970s, which was on account of an oil embargo. Further, low real rates and the existence of subsidies, among many emerging market countries, indicate the willingness of authorities to accommodate this shock.
In India, manufacturing inflation at 10.7% is very high by historical standards. As of now, this measure has an upward bias, given that steel producers are under pressure to increase prices. In the case of the mineral oil index, the following is illustrative of the incomplete passthrough — international crude prices rose by 130% from $57 a barrel in February 2007 (when domestic prices were reduced) to $125 a barrel. During the same period, the mineral oil index in the WPI (Wholesale Price Index) has only increased by 27%. The primary articles index at 10.15% is also elevated and unlikely to ease judging by the recent trends in monsoons.
It should be noted that the economy is witnessing aggregate demand pressures. This is evident from continuation of investment demand, revival in growth of consumer durables, widening of the trade deficit and fiscal pressures due to subsidies, Pay Commission recommendations and the farm loan waiver. Non-food credit growth at close to 26% is high and almost 6 percentage points above the RBI’s target. Further, M3 (the widest measure of money supply, this reflects the entire money supply in a country) growth at 20.5% is above the revised target of 17%.
However, there are some positive signals from reserve money (RM) growth. Adjusted for CRR (cash reserve ratio) increases, RM growth is lower at 18.5% compared with 22% last year.
In the current scenario, government spending rather than increase in foreign exchange reserves will drive RM growth. Fiscal slippages coupled with RBI’s funding of the fiscal deficit can possibly undo the recent moderation in RM growth.
In an environment of limited spare capacity, further increases in policy rates would be required to moderate aggregate demand and respond to inflation. It would not be advisable to use currency appreciation as a tool to lower inflation. This would be a risky strategy in a backdrop of global risk aversion, volatile capital flows and a sizeable terms-of-trade shock.
Srinivas Varadarajan is executive director, chief investment office-Asia, JPMorgan Chase Bank. The views and recommendations expressed here are solely those of the author.