Abheek Barua: The real case for tightening money

But normalisation does not mean a sudden and aggressive shift in policy stance.

The problem with the current debate on monetary policy and inflation is that it is mired in the narrow question of whether monetary action, be it excision of liquidity or a hike in policy rates, can bring food prices down. It should not take high economic theory to predict that a move by the Reserve Bank of India (RBI) at this stage will not miraculously bring the price of rice, eggs or tomatoes down overnight. It is perhaps true that excess liquidity does abet speculation and hoarding or helps firm up inflation expectations. Monetary tightening will help curb this a little but its effect is likely to pan out only over a period of time. It will not be the quick remedy that those (and there are indeed many) clamouring for a rate hike believe.

So, it is about time we jettisoned this pointless debate and moved on to something that is more substantive. It is, I believe, time to revisit the monetary policy question at this stage not as a magic cure for high food prices but because the economy seems to be recovering from the slowdown much faster than most analysts expected. This includes RBI’s own research division that forecasted a 6 per cent growth this year. Going by the first half’s GDP growth estimate of 7 per cent made by the Central Statistical Organisation (CSO) and a number of other indicators, GDP is likely to grow by at least 7 per cent for 2009-10 as a whole. If the trends in industrial growth sustain and agriculture fares better next year, it is quite likely that 2010-11 will clock growth of close to 8 per cent. I am a little sceptical though of the possibility of returning to 9 per cent growth in a hurry.

The question that then needs to be answered is: Can RBI afford to continue its unprecedented, super-accommodative policy stance when the economy is showing signs of acceleration? If it cannot, how aggressively should it reverse its stance? Should it start with a relatively mild gesture like hiking the cash reserve ratio (CRR) a little, or should it go the whole hog and raise policy rates as well?

I would argue that the data on growth does call for some degree of normalisation in monetary policy. It is not just the headline growth number of 7.9 per cent for the second quarter of 2009-10 (or 7 per cent for the first half) but the nuances of some of the recent macro-data releases that deserve close attention. If we look at the breakdown of GDP growth, both private consumption expenditure and investment expenditure (gross fixed capital formation to be exact) have shown considerable traction in the second quarter of 2009-10. Consumption grew by 5.6 per cent year-on-year in the second quarter of 2009-10 and investment by 7.3 per cent. In the first quarter, they had grown by a meagre 1.6 and 4.2 per cent, respectively. This suggests that growth is not just a chimera created by government stimulus. Besides, growth in the index of industrial production has not just sustained, it has also become more broad-based with significant contribution from all its components.
 

INDUSTRIAL GROWTH IS GETTING MORE BROAD-BASED
	Consumer non-durables	Consumer durables	Basic goods	Capital goods	Intermediate goods	General
Q2FY09	1.0	10.8	4.7	13.2	-1.7	4.7
Q3FY09	3.3	-1.8	2.4	3.8	-5.8	0.8
Q4FY09	1.2	5.6	0.4	5.0	-2.7	0.5
Q1FY10	-0.5	15.6	6.3	2.0	7.4	3.8
Q2FY10	9.9	22.2	6.9	8.3	11.7	9.2

Continuing with a loose monetary policy at this stage has a number of associated risks. For one, continued monetary expansion coupled with a pick-up in the economy could sow the risks of demand-driven inflation. Easy money and rising growth is historically associated with the phenomenon of too “much money chasing too few goods”. There is an interesting twist to this. Evidence for the developed economies shows that high non-core inflation (food, fuel etc.) driven by supply-shocks actually dampens core inflation. The intuition is simple. High prices of essentials, such as food, eat into the income left over for discretionary prices and depress their demand. High prices of rice and dal could mean that households would think twice about buying a new DVD player or TV set. As the price of essentials (food in this case) drops, demand for core items could actually pick up and drive up core inflation. RBI needs to be prepared for this.

Second, the sharp rise in food prices could, at this stage, be a supply-side phenomenon but could embed itself as a more permanent inflation-driver if it leads to a process of renegotiation of wages. Since wage-contracts are not revised on a continuous basis but at discrete intervals, the inflation impulses from wage-revisions play out over a period of time. The ability of workers to re-negotiate wages depends on the demand for labour that, in turn, depends on underlying growth. In short, monetary policy should be sensitive to the fact that accelerating growth could suddenly create situations where demand runs ahead of supply and prods inflation up. Central bankers often take policy steps to “stay ahead of the curve” as marketmen like to put it. It is perhaps time to take that step.

But normalisation or “staying ahead of the curve” does not mean a sudden and aggressive shift in policy stance. It really would not hurt much to wait for the monetary policy day on January 27 to announce the changes instead of doing it earlier.

Should RBI start with a CRR hike, change the reverse repo and repo rates or both? Quite honestly, I don’t think it really matters. For one, credit demand is weak and it will take a while and few more monetary steps before it actually “translates” into higher lending rates. The idea is not to ensure that monetary tightening immediately impacts the cost of borrowing; it is instead to send a message that the regime of easy money and exceptionally low rates will not last eternally.

A CRR hike is seen by both the markets and industry to be milder than a reverse repo rate hike but works like a tax on bank deposits. This messes up all the cost and price calculations for banks. I will not be surprised if most bankers actually prefer a hike in the policy rates to a change in CRR.

However, if indeed, RBI believes that liquidity excision through a CRR hike is the softer option, it might choose this over a rate hike for two reasons. First, it might want to wait for the fiscal deficit projections and the government bond issuance figures for 2010-11 that will be announced in the February Budget before sending a explicit rate signal. A combination of a rate hike and an unexpectedly large government-borrowing programme could send bond yields skyrocketing and that’s something that RBI, as banker to the government, might want to avoid. Second, credit disbursal is weak though credit sanctions by banks have picked up. RBI might want to see some sign of these increased sanctions to translate into actual credit off-take before upping the policy rates. Else it might just run the risk of taking away the proverbial punch-bowl before the party has begun.

The author is chief economist, HDFC Bank. The views expressed are personal