A re-emerging dilemma

Apparent hardening of inflation means less room for RBI

Three monthly data releases last week have raised questions about the state of the economy and the appropriate policy responses to it. On the positive side, the Index of Industrial Production (IIP) numbers for January indicate that the recovery that has been seen over the past few months is still on track. The overall index has increased by 2.6 per cent over a year ago, while the manufacturing component, accounting for over 75 per cent of the basket, has gone up by 3.3 per cent. This takes the increase in the overall index for the April-January period to 2.5 per cent - but manufacturing is still catching up, with the 10-month increase being only 1.7 per cent. At a disaggregated level, capital goods are looking fairly robust with an over 12 per cent increase in January. However, consumer durables are still very sluggish, with a decline of over five per cent in January that at best moderates the 10-month decline to just under 15 per cent. Of course, the larger question that arises about the IIP numbers is their consistency with the new gross domestic product (GDP) series, which shows the manufacturing sector performing at a much better clip than the IIP does. While the discrepancies between the old and the new series are yet to be sorted out, the value of the IIP series as an early indicator of economic performance will inevitably be viewed with scepticism.

On the negative side, the Consumer Price Index (CPI) numbers for February have revealed inflation to be somewhat higher than expected, coming in at 5.37 per cent. This has dashed hopes of another policy rate cut by the Reserve Bank of India (RBI) in April, causing markets to decline sharply. While this reflects positively on the RBI's credibility on inflation control, it also, inevitably, dampens prospects of monetary policy reinforcing whatever forces are currently driving the recovery. It also raises the question of whether the central bank was too quick to cut the policy rate after the Budget, when the inflation data were only about a week away. On the trade front, the data for February have showed exports, in both dollar and rupee terms, declining by over 15 per cent from February 2014. Imports have declined by roughly the same rate, in line with expectations, given the trends in oil and other commodity prices. However, a sharp slowdown in exports in a scenario in which the US economy is recovering points to a loss of competitiveness, to which one contributory factor could certainly be the appreciation in the rupee's real effective exchange rate (REER).

From a policy perspective, these patterns appear to be pulling in opposite directions. Lacklustre growth in industrial production and the decline in exports both support stronger stimulus from the monetary policy, involving both lower interest rates and measures to prevent rupee appreciation, if not induce some depreciation. However, the apparent hardening of inflation, particularly as it comes in the wake of the formal adoption of an inflation-targeting regime, implies both less room for interest rate cuts and the benefits of a stronger rupee. In its policy statement, the RBI was clearly wary of accepting the new GDP numbers, which would have clinched the argument against further easing. But the inflation numbers may have tilted the scales in that direction.