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T. B. Kapali

ARRESTING the rise in headline inflation is now the dominant objective of economic policy. There can, of course, be no second thoughts about the merits of maintaining stable price levels — meaning, in practical terms, a moderate rise in general price levels of, say, 4-5 per cent per annum. Therefore, when price level growth seems like getting too close to double digits, there is justifiable all-round concern. Official policy action to counter the price pressures, to recount, has been on all fronts: Fiscal, monetary and also moral suasion.

More than the prevailing level of the Wholesale Price Index (the inflation gauge in India) itself, inflation expectations are playing a big part in the current decisions of various economic agents be they financial market participants, retail households, or even policy-makers such as the government or the central bank. In fact, from a market or economic standpoint, it would be more critical to arrest or stifle expectations about future inflation to ensure stable overall macro-economic conditions.

For, short-term reductions in the inflation numbers can be brought about by official policy action — say, by arranging imports of essential commodities that have experienced price pressures. There can also be the arithmetical effect. For instance, on a point-to-point basis between August 23, 2003 and August 21, 2004, the WPI moved from 173.8 to 188, or a rise of 8.2 per cent. At the same time, between end March 2004 and August 21, 2004, the WPI rose only 4.3 per cent, from 180.25 to 188. It is clear from these numbers that as we move further into the year, the WPI is going to be calculated with reference to a bigger base, much closer to 180 than 173 which is the August 2003 number. And against a bigger base, the on-going WPI level would represent only a smaller percentage increase. So much for the prevailing level of the WPI.

The real focus should, therefore, be on inflation expectations and management of those expectations. It is because of this reason that monetary policy action against price pressures always has a forward approach. It also meshes in with the fact that monetary policy moves have only a lagged effect on inflation.

Whatever the inflation expectations of the Government/the central bank, financial market participants — commercial banks, institutional investors such as mutual funds — seem to be acting on the view/expectation that inflation globally is on the rise, could move up further and higher interest rates are needed to keep price level movements in check. There is also the view that interest rates in India would not rise immediately given the level of liquidity in the financial system. Another significant point made by this school is that India has to go along with the global interest rates cycle, which is trending higher on account of elevated inflation expectations, since India has progressed to a good level of integration with the global economy. Two questions arise here: Are global inflation expectations uniformly trending up now? And, what is the level of integration and sensitivity of the Indian economy — particularly the financial markets — to global interest rate moves?

As this piece is being written, comes an assertion by the Bank of Japan — the central bank of the world's second biggest economy — that its ultra-easy monetary policy stance is set to continue for quite some more time. The BoJ says that it will attempt a gradual reversal of its super-easy policy only on firm indications of a sustainable rise in consumer price levels. And, it does not see this happening in the near future — say, at least for the next 12-month period. Leave alone sustainable rise in the consumer price index (CPI). It is a fact that the CPI in Japan has not yet started rising. If not in deflation mode, it is at least stagnant.

The Euro Zone has not seen the kind of downward pressures on the price level as witnessed in Japan. But it is not witnessing any serious upward pressures either nor is it expected to in the ensuing period. General price level growth in the Euro Zone broadly is around 2/2.5 per cent and has been in this range so far through the current oil price cycle also. (The ECB has an inflation target of 2 per cent.) Energy prices alone in August in the Euro Zone were 7 per cent higher than in August 2003.

It is, of course, developments in the world's biggest economy, the US, that financial markets everywhere are focusing on. And it has truly been a mixed bag of economic data from the US over the past half year. The financial markets - exchange rates, interest rates, bond yields - have been swinging quite noticeably, responding to each economic data release on the downside or on the upside.

The US Federal Reserve, of course, has initiated a programme of tightening rates. But the tightening cycle this time around is subject to a high degree of uncertainty as to its length and magnitude . Simply because even the Fed is not categorically stating that price level growth is anywhere near the danger zone. In his Congressional testimony on the state of the economy and economic outlook last week (September 8), the Fed Chairman, Mr Alan Greenspan, pointed out that despite the stiff trend in oil prices in the past half-year, inflation and inflation expectations have eased in the US. Subsequent to his testimony, the August 2004 CPI (ex-food and energy) has come in at +1.7 per cent over a year earlier and including energy/food prices, was up 2.7 per cent — quite in line with the trend of the past few years.

Keeping all this in view, it is a little difficult to accept the proposition that inflation expectations globally are up and higher interest rates are here to stay. The other point is about the "high" level of integration of the Indian financial system with the global system. This, it is believed, makes it inevitable that Indian interest rates follow global rates on the way up.

Now, there is quite some uncertainty as to whether and how strong the global interest rates tightening cycle is going to be this time around. Even accepting that inflation expectations everywhere are up and interest rates have to move north and quickly, the "integration" argument cannot be accepted easily. Market observers have just to note this development: On August 12, 2004, just two days after the US Fed raised its target interest rate by 0.25 per cent to 1.50 per cent, the South Korean central bank cut its official target rate by 0.25 per cent to 3.50 per cent.

The Bank of Korea's move stunned markets and observers everywhere. But after the initial noise and confusion markets have settled down. They seem to have accepted the BoK's reasoning about the transient nature of the present price pressures (oil related) and of the need to consolidate overall demand in the economy in the backdrop of last year's recession.

It will be interesting to know which economy is more closely integrated to the global markets — the Korean or the Indian?

(The author is Associate Vice-President — Treasury — ING Vysya Bank Ltd. These are his personal views and do not represent those of his employer.)

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