What does one do, when the statistics tell a different story than the fundamentals? Does one set an expansionary or a contractionary policy? More importantly, how does this affect the roller coaster ride that we call the Indian economy? These are probably the biggest dilemma facing the Indian monetary policy makers now.
Often the views taken by the policy makers are with a short term objective in mind to address immediate issues. However, unplanned short term views often lead to distorted long term policies further resulting in monetary destabilization.
Let us look at the case of what everyone is terming “negative inflation”. India’s wholesale prices levels fell 1.6% during the week ending 6 June, compared with the 0.13% increase the previous week, the first time since the financial year ending March 1978 that the index has fallen. For all practical purposes, these statistics denote a contraction in demand, lower manufacturing activity, higher inventories and a drop in sales. At a worst, this creates a vicious circle of low demand and high supply. Sustained negative inflation or deflation in general is a serious issue and an expected consequence of a severe recession.
However, let’s look at this a bit more carefully. At first, one must differentiate here between the wholesale price index (WPI) and the consumer price ndex (CPI). Usually, advanced economies track inflation based on the CPI. In India, general inflation is published based on the WPI which tracks yearly rise in prices at the wholesaler level. Typically, the CPI and WPI also differ on the commodities they track. The WPI tracks a larger basket including industrial commodities. Therefore, the inflation figures reported here are not related to inflation as one would see in advanced economies. In the Indian case, it is important to see whether the negative inflation persists in the long run.
One may argue that given the global economic meltdown and the coupling effect, such a situation is expected. However, the facts differ. There are a various reasons why the WPI has shown a decreasing trend. Primarily, it is the base effect. Further, oil prices have decreased significantly in the past months from levels reported in the past year. Prices of some commodities have also declined.
However, these are not expected to have a long term effect. Moving forward, oil prices are firming up and commodity prices are increasing. Further, monsoon delays tend to lead to increasing prices of essential commodities and food products leading to inflationary trends. A number of indicators show that basic food prices still remain high affecting supply and leading to expected increase in demand. Industrial output also remains positive. Ironically, while the WPI was showing a negative trend, the CPI still remained buoyant at around 8%.
The Reserve Bank of India, or RBI, in the past few months has several times revised policy rates and reserve ratios as a reaction to the global financial crisis. Though lagged, the domestic economy is responding moderately to such policy measures. It is expected that the result of the stimulus package will boost demand. The results are there for everyone to see. Industrial output has increased gradually. The interest rates have also reduced from their peak levels reported during the middle of last year. In the past month, positive investor sentiments, higher stock market levels, buoyant foreign exchange reserves and stable election results have had the desired impact.
A lot of the short term imbalances are expected to self correct without the need for any further intervention. While short term rate cuts may be expected, long term fiscal measures may prove to be more beneficial. It is important that focus remains high on long term fundamentals, restoring the economy to a high growth path and making sure exports recover from the effects of the global downturn.
Therefore, it is important now that the RBI does not react hurriedly to the negative inflation and focus on long term market stabilization policies. The long term monetary policy needs to take into account that inflationary pressures are fairly strong inspite of not gaining much visibility in the WPI. It also remains a fact of life that in India, inflationary trends are driven by consumer demand which in turn leads to economic growth.
The RBI would further do well to let keep short term interventions at a minimum. Some focus on market stabilization through the trade in bonds may prove more beneficial than intervening in M1 variables. Long term monetary policy independent but aligned with proactive fiscal measures may be useful. For example, the government in turn may create an environment of sustainable economic growth through proactive fiscal measures like moderating taxation levels and raising investor confidence through industry friendly policies.
The author is a director with Deloitte.