Inflation starts to pinch growth

As inflation spreads to the core sector, the investment cycle may be hit

Balancing the holy trinity of growth, inflation and currency is increasingly becoming tough for the policy-makers. The Reserve Bank of India may continue with its hawkish stance on policy rates to anchor inflation expectations, but it has seemingly no silver bullet to deal with price rise without hurting growth. Last Friday, the markets had to deal with another negative surprise — higher than expected wholesale price index (WPI) figures. WPI for March rose 8.98 per cent year-on-year, higher than the consensus estimate of 8.36 per cent.

So far, the markets were concerned over the percolation of inflation from food to non-food categories and now it seems the fears were not unfounded. March has seen manufacturing inflation jump 1.4 per cent month-on-month, contributing 373 basis points to headline inflation of 8.98 per cent. The non-food manufacturing inflation (a proxy for core inflationary pressures) now breaches 7 per cent year-on-year in March, a 29-month high. The average WPI for FY11 stands at 9.3 per cent (February and March data still provisional). Clearly, days of 5 per cent inflation are over and a 6 per cent rate of inflation is the new normal.

This comes as a major shock because, till recently, it was widely believed that even though inflation was high, it was expected to gradually taper off as food prices would be reined in. But now non-food manufacturing inflation has gone up sharply (over 7 per cent), the risk of a slowdown in the investment cycle is near certainty.

Even though non-food manufacturing price rise is primarily due to rallying global commodity prices, high industrial commodity prices hit inflation expectation negatively. If the cost of industrial production is expected to rise, investment sentiment is adversely affected. Economists believe companies will reassess demand and accordingly look at capital expenditure.

With global commodity prices rising steadily, inflation will remain sticky, which will eventually take its toll on growth. Consumption and investment are the key components of growth. Siddhartha Sanyal, chief India economist at Barclays, explains how these two components affect growth: “While consumption contributes nearly two-thirds of India’s growth, around one-third is from investment. Consumption’s contribution is typically quite stable despite rise in prices. However, investment in more vulnerable. Since non-food manufacturing inflation is a proxy for core inflation, price rise puts pressure on inflationary expectation and interest rates, which negatively affect investment decisions. To that extent, it is a tough task at the moment for the central bank to convey that it’s serious about inflation, contain inflation expectation and yet support expectation of growth through policy intervention.” Elevated inflation, amid continued weakness in industrial growth, is complicating the central bank’s task even further. No wonder, most economists are cutting India’s GDP forecasts to 8 per cent levels.