It should be amply clear by now that the concept of policy co-ordination that exists in other countries is practically absent in India. Indeed, most people have understandably stopped expecting anything sensible from this government. However, the Reserve Bank of India (RBI) is one of the few institutions that seem open for business, but that automatically means it has to do more of the heavy lifting. But wholesale price index (WPI)-based inflation refuses to budge, despite a massive dose of 500 basis points (bps) of effective increase in policy rates since early last year. And economic growth is already in a sling since it probably won’t be higher than seven to 7.5 per cent this year and next. This is a poor performance for India, despite how respectable it might appear compared to other economies.
India’s inflationary pressures are a complex mix of demand- and supply-side factors, cover food and non-food categories, and are structural and cyclical in nature. Like the previous cycle, global commodity prices have also been a very important driver of inflationary pressures in the current cycle. Monetary tightening has been necessary to moderate aggregate demand, especially in the context of embarrassingly poor supply response.
But expecting interest rate hikes alone to neutralise the multi-headed inflation dragon only indicates a flawed understanding of the drivers of inflation. Indeed, many of the proponents of the 50bp-hikes seem to be scratching their heads and are beginning to focus more on the fallout for GDP growth, despite the still-high inflation. The remaining proponents need to realistically cut their growth forecast for this year and next.
One reason that is being overlooked for the lack of success in anchoring expectations is that RBI has inadvertently compromised the effectiveness of its own tight monetary stance by the way it signals and complements it. This is unfortunate since RBI has undertaken some welcome initiatives to enhance its communication. But when it comes to central banks, effective but less frequent communication is always better than more frequent but less effective communication.
There are five areas of potential improvement, that, if adopted, will be effective in complementing other measures in anchoring expectations. One, RBI mainly focuses on the short term, despite the well-documented lags in the transmission of monetary measures. It announces the one-year forward WPI inflation and GDP growth forecasts in the annual policy in April or May, and then sticks with the end time frame but revises the forecasts along the way, if needed. Thus, in January 2011, RBI was still talking about end-March 2011 inflation forecast, as if its action in January would affect the March outcome.
RBI should announce at least two-year forward forecasts for key variables since the policy path cannot be divorced from the outlook for growth and inflation in FY13. Thus, in the upcoming mid-year review, RBI should also indicate its outlook for FY13. Its medium-term guidance of four-to-five per cent inflation rate borders on being immaterial, since it has no specific time frame. Further, in recent years, RBI has been guiding its inflation to be well above that range. In fact, even in the current year, RBI has revised its inflation forecast upwards despite more interest rate hikes.
Two, RBI’s GDP growth forecast of eight per cent appears too optimistic. It is indeed puzzling that RBI thinks it can bring inflation down while GDP growth is eight per cent, which, it believes, is the trend growth rate. The reality is that we are probably on the cusp of sub-seven per cent growth, which should be labelled as a hard-landing for India. Cutting the growth forecast will also help manage inflation expectations.
There appears to be a big disconnect between the picture of strong aggregate demand painted by RBI and the on-the-ground reality, despite the ongoing uneven deceleration. It cites tax collections and credit growth figures to justify the strength of the aggregate demand. But these are nominal data and are, thus, contaminated by high inflation. Thus, though they correctly indicate that the underlying weakness in the economy is not as bad as what the monthly industrial production data suggest, they also hint that the strength is not as strong as what RBI will have us believe. There is something puzzling in RBI indicating loan growth as a sign of strength but banks indicating there is not much demand for funds.
Three, disappointingly, RBI’s analysis appears to have become selectively self-serving. The June industrial production was significantly affected by a surge in the volatile capital goods segment; excluding capital goods, industrial production was quite weak. However, a senior RBI official reportedly indicated that the strong data validated its guidance that the economic slowdown is not broad-based.
Now, in July, capital goods affected industrial production in the reverse direction. But in its September policy statement, RBI chose to flag only that the July industrial production excluding capital goods was not as weak as the headline number. Surely RBI realises that the volatile capital goods segment can affect both ways but one wonders why it preferred to present the strong data image rather than a balanced and objective view.
Four, RBI should clarify how it now thinks about exchange rate pass-through. In the September policy, it indicated , “…the rupee has depreciated, which may have adverse implications for inflation.” But in the past the RBI had maintained that the pass-through was small. Has its thinking changed and what prompted the change?
Five, RBI has been placing significant importance on WPI-core (non-food manufactured goods) inflation but, strangely, does not announce a forecast for it. Further, it is focusing more on micro developments, such as corporate margins, in its policy statements and decision making but without any clarity on the cross-section of companies it is using or the range of outcomes that will make it comfortable.
The bottom line is that RBI’s approach with respect to the mechanics of its guidance has compromised the effect of its tightening on expectations. Add to this the defective thermometer in the form of WPI that RBI uses to set the interest rate policy and it is not surprising that expectations are still not well anchored. Admittedly, there are several things that are not in RBI’s control. But surely more effective guidance is not one of them.
The author is a senior economist at CLSA, Singapore.
The views expressed are personal
