Overheating or not?

The mid-year review of the economy, placed before Parliament by the finance ministry on Tuesday, in compliance with the requirements of the Fiscal Responsibility and Budget Management (FRBM) Act, presents the ministry's view on whether the Indian economy is "overheating" or not. This presentation has to be seen in the context of the apparent difference of opinion between the Reserve Bank of India (RBI) and the ministry on the growth-inflation scenario and the appropriate policy responses to it. Over the last year or so, the RBI has regularly raised its benchmark interest rates, based on its assessment that growth and inflation rates were both in a range which suggested that inflation may accelerate because the economy was producing at levels close to its full capacity; in short, overheating. The finance minister has, on occasion, publicly expressed a view on interest rates that has been at variance with the RBI perspective. A few months ago, it was reported that the ministry asked public sector banks not to hike their lending rates, for fear of derailing the growth momentum. This document provides an analytical foundation to the ministry's view on the matter.

It lists a number of indicators, whose movements are associated with overheating""the current account deficit, the contribution to growth coming from investment activity and the significance of speculative debt flows from abroad. All these, it argues, are inconsistent with the conclusion that the Indian economy is overheating. It also cites historical evidence to show that countries have managed to grow for a decade or more at a stretch, at rates over 10 per cent, without running into capacity constraints. Finally, it argues that moderating oil prices reduces one potential threat against macroeconomic stability. The bottom line, as far as the ministry is concerned, is that overheating may be "less real and more imaginary".

Does this constitute a formal challenge to the RBI's reading of the macroeconomic situation and the policy moves that have resulted? It certainly sounds like it. The review does leave some room for reconciliation by indicating that monetary policy should ideally be based on future threats of accelerating inflation and not on past patterns. But that is not a complete endorsement of the RBI's current position. At the end of the day, looking at the RBI's statements on October 31 and December 8 and contrasting these with the mid-year review, it is clear that disagreement prevails. This does reinforce the image of the RBI as an independent authority; on the other hand, it also opens up the possibility of macroeconomic policy being made on conflicting premises, which cannot be a good thing.

On a related issue, the review goes into some detail on the drivers of the recent spurt in inflation. It highlights the fact that a significant reason for this has been the huge increases in food prices across the board""cereals, pulses, vegetables and fruits. While some palliative measures have been taken by the government, such increases (despite a not disastrous monsoon) reflect the appalling conditions in food production, storage and distribution. One macro-economic implication of the predominance of rising food prices in the inflationary process is that demand-side measures like interest rate increases will not help much; aggregate demand for food is insensitive to the GDP growth rate, unlike other channels of spending. Clearly, this is arguing against the RBI policy of hiking interest rates and squeezing liquidity.