RBI should have tightened more earlier

RBI should have tightened more earlier

It is undeniable that activity in India is slowing. July industrial production (IP) growth and August PMI (purchasing managers’ index) have fallen to their lowest in more than a year. Add to that the weak economic data coming out from the rest of the world, and it isn’t hard to imagine why business is clamouring for at least a pause in the tightening and the market is pricing deep rate cuts in the near term.

And after Friday’s rate hike, questions will be raised whether in the face of the slowing economy this was the right thing to do.

But the market isn’t asking the right question. True, the economy is headed to decelerate further. Indeed, the 11 rate hikes over the past year were designed to do precisely this. The question facing RBI is not whether the economy is slowing, but whether it is slowing sufficiently for inflation to come down on its own. And RBI rightly inferred in Friday’s policy statement that it isn’t.

Take away the volatile capital goods component and non-capital goods IP grew 6.7% in July, the fastest in four months. August PMI has declined, but it still is one of the highest in the world. Indirect tax for the first five months of this fiscal year is up 24%, well above the budgeted target and despite the cut in customs duty on petroleum products.Even after slowing from its frenetic pace, exports grew 44% in August and import growth jumped to 41%. All this indicates that activity has not slowed as much as feared.

But the proof of the pudding is in the eating. And this is where Wednesday’s inflation print for August looked decidedly unnerving. Far from slowing, inflation accelerated to 9.8%. Domestic input prices rose sharply and, ominously, core inflation jumped to its highest sequential increase in the four months, pushing the year-on-year rate to 7.7%, twice its historical average. So, even in August, domestic demand was sufficiently strong for firms to keep passing higher input costs to final goods prices.

The real problem is that for core inflation to start declining on its own capacity, constraints have to ease sufficiently. Last quarter GDP (gross domestic product) growth came at 7.7%. Our best guess is that trend growth has declined to around 7.5% and the output gap (actual GDP less trend GDP) has increased to close to 1%. For core inflation to come down, this gap needs to turn negative as it did in 2009. And this requires growth to slow significantly below trend, which the data isn’t indicating so far.

So RBI needed to tighten further. But it should have raised rates more aggressively. Doing so would have allowed it to bring the tightening cycle to an earlier end and provide the space to pause in October. Now, as RBI nearly explicitly stated, we have to brace for more rate hikes. The earlier inflation peaks and growth troughs, the earlier the macroeconomic uncertainty, which has been the key factor holding back private investment, will be resolved. And India Inc. can go back to rebuilding capacity, which is what is really needed to bring down inflation in the medium term by increasing trend growth.

Jahangir Aziz is India chief economist at JPMorgan Chase.

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