The Hindu Business Line : Mid-summer economic developments and policy perspectives

Seen in the background of the economic developments of the last two months, commodity and asset prices, growth and policy initiatives should be interpreted with care to effect the right policy initiatives.

Economic developments since the second week of May have revolved around commodity and asset prices, growth and policy initiatives. Recounting them in brief would help understand the policy initiatives that can be expected in the near future.

It all started with concerns on oil price uncertainty and perhaps also with the much discussed macroeconomic imbalances in the international economy.

These concerns influenced the domestic economy in more ways than one, with surprising suddenness. The BSE Sensex, the barometer of investor sentiment, was the first to feel the impact. It began to decline from 12,612 on May 10, on reports of the withdrawal from the market of foreign institutional investors.

The assurances of the Government and the central bank that the latter would stand ready to infuse liquidity into the market gave some respite but the Sensex exhibited extraordinarily large inter- and intra-day volatility. Even the news that is conventionally viewed as good could not stop the downward movement of the Sensex from being larger than the upward ones. The Sensex, as a result, fell to less than 9,000 within a matter of five weeks. Right now, it is ruling around 10,500. But there is still considerable volatility.

Inflation expectations

Among the other assets, housing and real-estate prices have been moving upward. The rupee has depreciated against the dollar.

The official response to increase some oil product prices along with cuts in import tariffs and relief on sales tax in some States gave rise to fears of ballooning commodity prices. Meanwhile, came the good news about the economy growing 8.4 per cent in 2005-06 and the expected continuance of good performance of services and manufacturing sectors this year too.

Notwithstanding the expected good output performance, the wholesale price index began to move up from early June. Year-on-year headline inflation was placed at over 5 per cent. The prices of consumer goods such as vegetables, pulses and sugar shot up sharply, forcing the Government to think of importing certain critical items, cutting import duties on some and banning exports of some others.

Given the inflation expectations and the increases in interest rates abroad, the Reserve Bank of India announced repo and reverse repo rate hikes ahead of the first quarterly review. This was followed by the decision to increase the volume of government borrowing in June, thereby fuelling expectations of a rise in bond market yields and further hikes in the interest rates. The defence for the policy rate hike is to maintain the hitherto existing interest differential between the Fed funds rate and the Indian policy rate.

For sustained growth

The story of the midsummer developments has a moral. Policy-makers will find it difficult to face unfavourable market expectations and the general public's resentment if actions are not taken quickly to reduce the variability in prices, be they related to consumer goods or equity stocks or housing, even when growth impulses are very much in evidence. What the public — and the markets, by inference — want is sustained growth with stability.

The literature on monetary policy refers to the need for central banks to be concerned about output or growth variability and inflation or price variability. Central banks that target inflation monitor the movements of consumer prices to reduce price variability. Price stability promotes growth and is assumed to limit output variability.

Variability in asset prices, however, is often ignored in the conventional literature, mainly because the connection between asset prices and monetary policy has not been established decisively.

In the Indian context, however, there is a need to interpret the very concepts of growth and commodity inflation variability with some care. The preponderance of people living in poverty and the existence of huge income inequalities require that commodity-producing sectors perform well. At present, more than half the overall growth is contributed to by the services sector. And the share of the services sector could go up further. In view of the likely decline in the share of agriculture and manufacturing sectors in the overall output, these sectors can retain their contributions to overall GDP only by recording high growth rates.

Commodity price variability should be based on fluctuations in the prices of what consumers buy regularly, such as foodgrains, pulses, vegetables, milk, fish, sugar, tea, fuel, power, and a few processed foods for their sustenance and for improving their welfare. Limiting the variability implies that the prices of these goods should not be allowed to move up sharply.

But regular monitoring of prices of these goods alone is not enough: it should be followed by quick actions to contain increases in prices well before they prick the margin of tolerance of the people.

Stabilising prices when they are already ruling at high levels is only the second-best solution, for there would still be loss of real welfare in the short run.

Asset price variability would, through the wealth effect, shift the existing configuration of consumption and investment in the near and mid-term. Besides, it makes future inflation expectations somewhat fuzzy. Given the strong relationship between the primary and secondary markets for assets such as equity and real-estate, growth prospects would be in jeopardy to the extent investment decisions are adversely affected by asset price variability.

Interest rate variability

How should one view the variability in market interest rates? The US experience of the 1970s highlighted its deleterious effects on output growth and inflation. In the present situation in India, commodity and asset price variability co-exists with expected good growth prospects. Will this variability be accentuated if market interest rates are allowed to move up?

It is necessary, in the first place, to know the level beyond which domestic interest rates would discourage investment. It would be also necessary to know whether such a level would help anchor inflation expectations around the tolerable inflation rate. In other words, the authorities would need to divulge the interest rate path that is consistent with the realisation of such objectives as growth and inflation for the year ahead as well as for the medium term.

If the current interest rate is positioned on or near such a path, what would be the rationale behind the maintenance of the differential between the Indian policy rate and that of, say, the US? Is it to do with the degree of linkage between the Indian and the rest of the world? Some observers expect the Indian policy rate to move up following the hike in the Fed funds rate of June 29.

It is often taken for granted that policy rates and market rates move in tandem but if the differential between the two rates widens further from what has been the case so far, one would wonder what would be the impact of interest rate variability on growth and commodity price inflation a year from now.

(The author, a former Executive Director of the Reserve Bank of India, can be reached at asurivasudevan@hotmail.com)