By holding policy rates steady, the Reserve Bank of India (RBI) did not surprise this time. In the build-up to the July policy, the RBI had, at various fora, been drumming the issue of sustained high inflation in the country. This had muted market expectations of immediate rate cuts and its action of keeping interest rates unchanged was in line with these expectations.

But the RBI did trim its growth forecast to 6.5 per cent (from 7.3 per cent) and raised the year-end inflation guidance to 7.0 per cent from 6.5 per cent. Slowing growth and rising inflation is a very unusual and unpleasant situation for any central bank to deal with.

Central banks in advanced countries and also in many other Asian economies are cutting interest rates to cushion growth. But the RBI finds itself constrained in easing monetary policy further. This is because inflation in India, unlike in other economies, has not come down in a manner commensurate with the drop in growth.

Persistent high inflation

The Indian economy’s ability to grow fast and maintain inflation at tolerable levels has clearly been eroded in the past few years. In 2011-12, for instance, inflation remained a high 8.8 per cent even though growth fell to 6.5 per cent. In the last quarter of 2011-12, growth slipped to 5.3 per cent, while inflation dipped only marginally.

India’s GDP growth has fallen below 7.5 per cent, the rate that the RBI regards as the potential growth. But WPI inflation continues to be at 7.25 per cent and CPI inflation is in double digits. The RBI believes that the primary reason behind stubbornly high inflation is loose fiscal policy focused on raising consumption demand rather than creating capacities.

One example of this is the sharp increase in rural wages (linked to MNREGA) but the weak supply response from agriculture. This has led to high and persistent food inflation. Similarly, by not raising fuel prices, the government manages to suppress inflation.

But this increases the spending on subsidy, which reduces the government’s ability to shore up the supply side via investments. These factors have contributed to persistence of high inflation.

There are further downside risks to the RBI’s revised growth outlook of 6.5 per cent for 2012-13. If the monsoon does not improve in August and September, poor agricultural performance can drag down overall GDP growth below 6.0 per cent. Material upside risks to inflation stem from a further increase in food inflation (due to monsoon failure) and from unwinding of suppressed inflation, particularly in electricity and diesel (because diesel prices have not been hiked for long, and only some States have increased electricity tariffs).

Our estimates suggest that inflation in commodities that account for about 12 per cent of the overall wholesale price index is suppressed. Diesel prices are yet to be revised up but the process of increase in electricity prices in many States will soon get reflected in WPI and CPI inflation.

Consequently, the low growth-high inflation mix could worsen further in 2012-13. The million dollar question is how and when will the economy come out of this low growth-high inflation trap?

Fiscal consolidation must

Interest rates are not the primary reason behind the current growth slowdown. So, cutting them cannot boost growth much, but can stoke inflation further. In a recent survey by CRISIL Research, over 70 per cent of the respondents cited policy logjam/delay in clearances (rather than a high interest rate environment) as the major reason for the investment slowdown.

The RBI’s discomfort with the current inflationary situation is evident as even non-food manufacturing inflation, treated as a gauge of demand pressure on inflation, remains high at 4.9 per cent and there is a risk of demand pressures resurfacing quickly.

To reverse the high inflation-low growth cycle, fiscal consolidation must begin, with a shift in the expenditure mix from consumption to investment. Although such fiscal correctives will take some time to dampen inflation, government support in easing supply-side bottlenecks will, nevertheless, be critical to reduce the fiscal pressure on inflation and create space for the RBI to cut interest rates to stimulate the economy.

To spur private investments and bring GDP growth closer to its potential (read 7.5 per cent), the government needs to, on a priority basis, speed up project clearances, sort out fuel linkages for power plants and bring greater clarity on the tax front. If this is topped up with a fresh dose of economic reforms focused on removing bottlenecks in infrastructure and agriculture, the economy’s growth potential too will get a boost. Till that happens, we may well have to learn to live in a low growth-high inflation environment.

(The author is Chief Economist, CRISIL. The views are personal.)

(This article was published on August 4, 2012)
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