Although retail inflation is trending down?to the lowest levels since January 2012?RBI governor Raghuram Rajan remains hawkish by keeping policy interest rates unchanged. Paradoxically, the IMF is even urging India to consider raising rates to bring down the persistently high inflation on a durable basis! What is the rationale for this single-minded focus on staring down inflation while India?s growth outlook appears muted? RBI and the finance ministry are set to finalise a monetary policy framework that will make the government responsible for fixing targets for retail inflation.
Evidently, the governor appears to be more worried about the upside risks for inflation than downside risks for growth. Even with the expected edging down of food inflation, there are indications that retail inflation might touch 8% by March 2015. That there might be possible upside risks to hitting the targeted 6% by January 2016. For such reasons, rising prices warrant a less accommodative monetary policy. But if the data indicates that the January 2016 objective is under serious threat, rates will be hiked. But if inflation comes down in the months ahead, RBI will reduce interest rates.
For all this focus on targeting retail inflation, the big question is whether monetary policy really helps in dealing with food prices? Interest rates have less of a role to play as this phenomenon is more on account of demand-supply mismatches and supply-side shocks arising from poor agricultural performance. Sluggish agricultural growth ensures that food inflation stubbornly persists in the system. With a monsoon shortfall of 12% this year, the kharif or summer crop will be adversely affected. The expectation of such a shortfall, in turn, fuels inflationary expectations that might prove to be self-fulfilling.
In this milieu, RBI hopes to contain inflation through higher rates and curbing money supply. Obviously, the expectation is that by choking off demand, inflationary pressures will be under control. But this policy will be more efficacious if higher food inflation reflects demand than supply-side constraints. True, there are theories that with higher incomes people are consuming more fruits, vegetables, eggs and milk products than before. Some economists argue that higher rural wages exert pressure on food prices. But will food inflation on account of these factors be controlled by monetary tightening?
Higher interest rates instead impact investments when a kick-start is needed to revive overall growth. The first quarter GDP performance this fiscal of 5.7% largely reflects the base effect of depressed growth of 4.7% during the same period in 2013-14. Rains were not timely for sowing operations in July this year on which the kharif crop depends. This is bound to be reflected in lower agricultural growth numbers in the July-September and October-December quarters. The prospect is for agricultural growth to languish at 1.9% this fiscal.
The outlook is hardly different for industry, which showed signs of revival during the first quarter of this fiscal. But soon thereafter the index of industrial output slumped in July. The slowdown in manufacturing has been accompanied by a contraction in consumer durable goods and capital goods production. Core industries like coal, crude oil, natural gas, refinery products, fertilisers, steel, cement and electricity also lost momentum in July. The upshot is that a boost to growth is necessary and warrants greater priority over inflation. Monetary policy can facilitate this through lower interest rates.
In the absence of such interventions, it is interesting that the World Bank is waxing eloquent over the so-called ?Modi dividend? that will take India?s growth from 5.6% this year to 6.4% in 2015-16. The animal spirits of investors may be alive and kicking but there have been no policy interventions as yet on the ground that have uplifted the overall growth outlook. The fact that India has slipped by three places to 134 in the World Bank?s latest global ranking of 189 nations on the ease of doing business is a problem that the government needs to urgently fix.
Keeping interest rates up?even if their impact on food inflation is somewhat exaggerated?perhaps has a rationale beyond targeting retail inflation. This pertains to the current state of global environment in which the most powerful economy in the world, the US, is winding up quantitative easing and is set to raise interest rates. The question is not if but only when. The US economy is now fast emerging as the growth engine of the world economy and the latest numbers indicate a further drop in unemployment rates, all of which may prompt the US Federal Reserve to raise interest rates.
RBI would loathe being more accommodative just when the rates firm up in the US, which will lead to a surge of foreign portfolio investments out of the economy. The rupee will take a huge hit in the process. Clearly, higher interest rates defend the value of the rupee when US rates are raised. It is true that monetary policy cannot simultaneously control inflation and stimulate growth. This dilemma becomes a far more difficult trilemma, if RBI is asked to also simultaneously defend the exchange rate of the rupee. At best, only two of these objectives can be satisfied. One of these should be boosting the flagging growth of the Indian economy.
The author is a Delhi-based economics and business commentator
