Editorial: The plot thickens

It has been a long time since a routine quarterly monetary and credit policy announcement has been the subject of so much speculation, even drama. While the weekly numbers for the Wholesale Price Index (WPI) have been pointing to a sharp surge in inflation, the monthly numbers for the Index of Industrial Production, on the other hand, until last month were indicating a definite loss of momentum for the industrial sector. From the perspective of monetary policy, these are contradictory signals and responding to any one poses a threat to the other. Against this backdrop, last Friday saw data releases for both indicators. The inflation rate is clearly entrenching itself in the danger zone, having reached 7.41 per cent after having touched the 7 per cent mark in the previous week. In contrast, the industrial production numbers reversed course somewhat after their plunge in January. Compared to the previous month's year-on-year growth of 5.3 per cent, the Index registered 8.6 per cent growth in February, among its more respectable performances over the past six months. This was buoyed by stunning 9.8 per cent growth in electricity and a solid 8.6 per cent growth in manufacturing. Still, for the April-February period, 2007-08 has seen a relatively modest performance for the general index "" 8.7 per cent growth compared with 11.2 per cent in 2006-07 "" and for manufacturing "" 9.1 per cent compared with 12.2 per cent.

On the face of it, the numbers tilt the scales in favour of an anti-inflation stance by the Reserve Bank of India (RBI) in its April 29 announcement. However, looking beneath the surface of both indices complicates the picture. Tightening liquidity by raising the cash reserve ratio and the repo rate will unquestionably reinforce the growth deceleration in industry, which has been led by the relatively interest-sensitive segments of transport equipment and consumer durables. Slowing demand in these would ordinarily, sooner or later, lead to falling prices, reflecting positively in the inflation numbers. However, in the current circumstances, metal prices, particularly those of steel, are at the heart of the inflationary surge in recent weeks. Given that these two segments are heavy users of steel, their ability to bring down prices of their products will be restricted by the further hardening of metal prices. Food prices, another contributor to the recent surge, are also insensitive to liquidity conditions and will only now respond to the abundance of rainfall during the forthcoming monsoon season.

But, doing nothing could also send the wrong signals to the market. By suggesting a weakening commitment to resisting inflation, the RBI could stoke inflationary expectations, which will then work their way through various asset prices, eventually deterring long-term commitments. This may well be a strong enough argument to justify a tightening of liquidity. The impact of such a move on the inflation rate may be minimal, given the significance of the contribution from food and natural resources, but its symbolic value will be considerable. Given the delicacy of the situation, it is quite likely that the RBI will wait until the last possible minute to make up its mind. By then, it will have two more weeks of data on prices to take into account. If these show some initial pay-offs from the various measures initiated by the government, it will tilt the scales in favour of the status quo.