Abheek Barua: Monetary policy - Beyond the boiler plate

Rising inflation or slowing growth - the RBI must decide which is worse.

The persistent volatility in the stock market and the prospect of slower domestic growth in the coming year should mean that investments in equities are a no-no at least for those with a relatively short investment horizon. The obvious alternative, going by the textbook, should be bonds. However, recent trends in the bond market seem to challenge this textbook wisdom. Bond prices have been falling. Going by the consensus in the market, they are set to fall further. For those more comfortable with yields rather than prices, bond yields (remember that yields are inversely related to prices) have been rising and are predicted to rise further. The benchmark 10-year bond yield is up by almost half a percentage point over its February levels. Traders at our bank's bond desk are convinced that there is more steam left yet.

One way to understand this conundrum is to view the Indian situation as a somewhat milder variant of the phenomenon called stagflation that has the Western economies in its grip. Stagflation, as the name suggests, implies the coexistence of a slowdown in growth with rising inflation, quite the converse of what elementary economic theory would suggest.

Thus, while the recent flow of output and related data point to the possibility of a palpable slowdown, headline inflation numbers have been ticking up. Industrial output for January, for instance, clocked a paltry 5.6 per cent. Credit growth (a fairly accurate indicator of demand conditions) for the last fortnight of February printed at 22 per cent. To put this in context, industrial credit demand grew by over 29 per cent in the same fortnight a year ago. Yet, inflation in the past weeks has been on an increasing trend "" the last data release for the week ending March 15 was an absolute shocker with the year-on-year wholesale price inflation rate printing at 6.7 per cent, almost a percentage point and a quarter above the RBI's tolerance limit of 5 per cent.

In short, the prospect of slower growth and the associated moderation in demand aren't helping to rein in price pressures. The corollary is that the usual prescription of easier monetary policy to prime growth is losing relevance. Central banks tend to fret more about inflation than growth and with inflation at these levels the RBI is unlikely to cut rates. The bond market is now actively "pricing" in a probability of some tightening in the monetary policy due in April and traders are dumping bonds. Equity investors, on the other hand, are unhappy with growth and are selling stocks.

The fact that fiscal policy has been expansionary in the middle of all this is not helping the bond market, either. Measures like the loan waiver for poor farmers or the hikes in salaries are in effect income transfers from the government to consumers. So are the large subsidies paid out to hold the price line for things like petrol and diesel. While these measures could help growth in the medium term, they increase the government's deficit and translate into larger borrowing requirements. The government turns to the bond market for funding this and as it issues more bonds in the market, prices dip and yields rise. The market reacted positively to the market borrowing number for 2008-09 of Rs 1,45,146 crore announced in the February Budget. However, the possibility of more cash calls to fund new expenditures like the salary hikes for government employees has reversed sentiment.

A possible rise in bond yields has implications that go beyond portfolio choice. Bond yields ultimately reflect in lending and borrowing rates and if they were to rise, the average interest rates in the economy would also tend to move up. The question is: can we afford a further rise in rates at this stage?

Any attempt to fight stagflation would mean that the central bank has to make an explicit choice and treat one of the two "" rising inflation or slowing growth ""as the bigger evil. The RBI has, until now, been in the anti-inflation camp choosing to rein in liquidity-fuelled demand rather than priming the growth pump. In making its policy choice going ahead, it needs to keep a few things in mind. For one, we no longer have the luxury of assuming that investment demand will remain solid irrespective of what happens to interest rates. Capital goods production is slowing and this is getting reflected both in macro-data like the index of industrial production and more informal data that companies are willing to share. A further increase could push the economy past a tipping point where capital formation could get affected over the medium term. This in turn could lead to a prolonged slowdown (remember the late nineties?). Besides, for a capacity-constrained economy like India, a slowdown in capacity expansion could breed price pressures in critical areas.

Second, the policy of monetary tightening over the past year has managed to wipe off the froth in a number of segments like housing where there were signs of overheating. Mortgage lending, for instance, has come down sharply over the year. The re-pricing of risk has taken care of excess capital inflows and this is likely to prevent large liquidity build-up going forward. Finally, central banks across the world are reconciling themselves to the fact that conventional monetary tools have a blunt edge when global commodity price trends are a big contributor to local inflation. The European Central Bank, which has an explicit inflation mandate, has not hiked rates despite the fact that European inflation rates have been way higher than the mandated level. The RBI should avoid giving a boiler plate response in a situation where most textbook predictions are failing.

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