In an ideal world, central bankers should be “forward-looking”, as the cliché goes, and should base policy decisions on their assessment of future inflation and growth rather than dwell on the past. In the real world, however, they tend to be guided by the ebb and flow of macroeconomic data that, by their very nature, relate to the past. It is thus unlikely that the Reserve Bank of India (RBI) will ignore the two key data releases of the past fortnight — the index of industrial production and inflation — in deciding its policy stance in the first ever mid-period monetary policy review due this week. Both data points, incidentally, would make a case for more monetary tightening. Industrial growth for July that printed at 13.8 per cent in last Friday’s release beat even the most optimistic expectation by a mile, suggesting that the manufacturing sector has lost none of its traction. Wholesale-price inflation for August clocked 9.5 per cent or 8.5 per cent, depending on whether one goes by the old WPI (with 1993-94 as base) or the revised index (with 2004-05 as base) that was released for the first time yesterday. Both inflation rates were way above the 5 per cent level that RBI targets. The global environment seems a little less intimidating than what it was even a month ago and that should give the central bank more headroom to push up rates without adverse consequences for capital flows and financial stability. Data from China released last week suggest that it is regaining some of its traction. US private sector employment data released earlier in the month were also encouraging.
That said, some caveats are in order. For one, the objective of monetary policy is to ensure a “soft landing” or a judicious balance between growth and inflation, not smother growth altogether. Liquidity in the money markets has been tight due to a combination of a large current account gap (and barely adequate capital inflows) and a subdued money multiplier. Banks seem to be on the verge of hiking lending rates spurred on by rising deposit costs. If monetary policy is seen to be too aggressive, the quantum of increase could be uncomfortably high in the coming months and that, in turn, could hurt growth. Besides, while industrial growth for July was indeed impressive, it relied heavily on the capital goods component that grew by a stupendous 63 per cent that month. This component of the index has been known to be extremely volatile and a number of economists point out that July’s growth was perhaps an aberration. Industrial growth could, they point out, moderate going forward. The same holds for inflation that certainly seems high for the moment but is likely to come down going forward on the back of softer agricultural prices and a favourable base effect. Finally, the global economy remains somewhat uncertain and favourable data for a month does not necessarily mean that the worst is behind us. Given these riders, the best course of action for RBI might be to hike rates a tad (a quarter of a percentage point in repo and reverse repo rates perhaps) but clearly indicate that it is nearing the end of the cycle of relentless hikes of the past few months. That would make it a truly “forward-looking” central bank.
