The last rate cut and first rate hike are always difficult to time. But the Reserve Bank of India’s (RBI) underlying tone in its October policy statement has turned from a neutral bias in July to something more hawkish, suggesting that policy tightening is likely in the months ahead. For now, RBI has preferred to err on the side of caution, until there is further improvement in private demand—a prudent response, in our view.
An economic recovery is usually led by a few sectors initially. As production rises, it generates more employment and creates demand. Growth slowly percolates to other sectors of the economy, making the recovery more broad-based. Rising asset prices, improving confidence and easier financing add to the momentum, creating a virtuous spiral. We believe this virtuous spiral is taking form in India. The manufacturing and construction sectors are building and paving the road to recovery, benefiting from the government’s fiscal stimulus, easing cost pressures and lower interest rates.
As the industrial sector strengthens, the benefits should trickle down to the services sectors, albeit with a lag. The crisis-hit financial services and real estate sectors are doing much better already. Anecdotal evidence suggests that employment prospects are also improving, which should support consumption even after the fiscal stimulus fades. Investment activity should benefit from better availability of financing, rising demand and the much-needed infrastructure investments —creating jobs and in turn supporting consumer demand.
Of course, the global economy is likely to take much longer to recover, and so India may take a few years before it rebounds back to 9% growth levels, but domestic demand itself could comfortably pull up growth to around 7.5-8.0%, in our view.
And what of inflation? Base effects have complicated assessing the true picture, but inflation drivers can be divided into two phases. Price pressures during the first phase have been fuelled by supply-side factors, led by higher food prices and a rebound in other commodity prices globally, adding to input cost pressures.
We are now slowly moving into the second phase, where the fundamental driver of inflation could shift from the supply to the demand side. Rising cost pressures and strong demand mean that firms are likely to slowly start passing on their higher costs to consumers. Therefore, anchoring inflation expectations is crucial at this stage.
Balancing the growth/inflation objective would suggest that conventional liquidity withdrawal tools should be used once credit picks up. Given the time it takes for a change in monetary policy to be felt, decisions ought to be based with fiscal 2011 in mind, not just fiscal 2010. Therefore, normalization of policy rates in early 2010 may be necessary to avoid steeper rate hikes later.
In the aftermath of the crisis, central bankers have many things to worry about apart from the typical growth/inflation dilemma—high government debt for one, which can risk crowding out private investments. More importantly, central banks can no longer lean against asset price bubbles. The latter is one risk that RBI seems alert to, and quite rightly so in our opinion.
Sonal Varma is vice-president and India economist, Nomura Financial Advisory and Securities (India) Ltd. The views are her own.
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