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Abheek Barua: Learn to live with the 'new normal'

India must reconcile itself to lower medium-term growth

Abheek Barua 

Indian economy watchers (including this paper) have advised Reserve Bank of India (RBI) Governor D Subbarao to do some straight talking. Instead of obsessing about the need to return to the “old normal” of a 5 per cent inflation rate, he has been counselled to prepare markets for a “new normal” in which the inflation rate will remain considerably higher than 5 per cent owing to a bunch of local and global factors. That, however, does not imply that the RBI can afford to wash its hands off inflation. Even if the new normal were to prevail, the RBI needs to give its best shot to lower inflation from the double-digit level to which it threatens to climb by the middle of the year to a more “reasonable” level of 7 or 8 per cent. In short, greater monetary tightening is warranted. The corollary, going by simple economic principles, should be lower growth. Thus, an integral part of the new normal is the acceptance of a lower rate of growth perhaps for a couple of years.

The risks and challenges for the RBI on the domestic front are now well known. High crude prices have meant that under-recoveries on diesel and petrol now stand at roughly Rs 16 and Rs 7 a litre, respectively, and a fairly hefty increase in their prices seems overdue. Given the political economy of how these things work in India, one could safely assume that these increases will be announced after the state election results are announced in mid May. That is likely to add quite a few basis points to headline inflation. A whole bunch of other commodities is putting pressure on inflation. Input price inflation (going by some estimates) was a whopping 11.5 per cent in March while output price inflation was a relatively meagre 5 per cent.

The risk is that if domestic demand conditions remain somewhat robust, manufacturers will try and pass these on to consumers as higher final product prices in a bid to protect their margins. Thus, the prospect of an inflationary spiral that feeds off rising input costs and then nourishes output prices looms large. The only policy action that could work at this stage is to try to stifle demand and curb pricing power.

While these forces and factors will play out in the domestic economy, their roots lie in international markets and economy. For one, commodity prices are riding on a combination of supply disruption (or fears of supply disruption) and surplus liquidity created by western central banks which continue to grapple with the aftermath of the financial crisis of 2008. While the supply dynamic of these commodities are difficult to understand and predict (who knows, for instance, how things in West Asia will pan out), the liquidity cycle is a little more predictable.

In fact, a major change in the global liquidity regime is due in June when the US Fed finishes with the last tranche of its quantitative easing programme (QE2). For the uninitiated, under this programme, the central bank was to buy back $600 billion of bonds from the markets between November 2010 and June 2011, releasing cheap dollars in the process. The question then is: Will the end of this massive liquidity infusion lead to a reversal in commodity prices and make life easier for the RBI and other emerging market central banks that are battling inflation somewhat unsuccessfully?

My sense is that it might be somewhat naïve to depend on this excessively to cure commodity price inflation. For one, as Fed Chairman Ben Bernanke emphasised in a recent press conference, the event is well anticipated. Markets tend to “price in” the impact of an expected event well ahead of its actual occurrence. The fact that commodity prices haven’t cracked yet suggests that prices will not fall off a cliff in July. It is useful to remember that the actual commencement of the QE2 was a bit of a damp squib. Its effects were priced a good couple of months before the actual event and the prices of an array of so-called risky assets – commodities, emerging market stocks and bonds, and so on – ramped up in anticipation. When the bond buy-backs physically started in November, these asset prices hardly moved. One could expect a similar phenomenon when the scheme winds down.

Besides, the US economy is not quite out of the woods yet. Growth rate for the first quarter slumped to 1.8 per cent and both labour and housing markets remain sluggish. The Fed seems to be going out of its way to assure the markets that though QE2 will technically end, the easy money regime will continue. One way to ensure this is for the Fed to keep reinvesting the maturing debt proceeds to keep the size of its balance sheet constant. The central bank is also likely to keep policy rates on hold at least until the first quarter of 2012. To cut a long story short, the impact of the end of QE2 on financial markets could be extremely muted.

The other event that could put the brakes on commodity prices would be a sovereign crisis in Europe. This would increase risk aversion and could trigger a sell-off in so-called risky assets. Again, the probability of that happening is low. Two things have been happening on this front. First, markets have learned to digest periodic news of fiscal or banking system stress in the smaller economies on the eurozone periphery like Portugal or Greece. Second, the risk of a large economy like Spain defaulting on its debt seems to have abated with major reserve-holders like China splurging on Spanish government bonds.

The global odds seem to be stacked against the RBI and a sharp sell-off in commodities doesn’t seem quite likely. There are two things that could tilt the balance. One would be a comprehensive resolution of the crisis in West Asia and North Africa. The other, and the more long-winded, process through which commodity prices could correct is when high prices (and the resultant high interest rates) themselves set off a palpable slowdown in emerging economies like India and China which constitute the bulk of global demand for energy and materials. Until then, the RBI will have to continue to raise rates.

The author is chief economist, HDFC Bank

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First Published: Wed, May 04 2011. 00:50 IST
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