It was a lot easier for the Reserve Bank of India to steer its policy measures around this time last year, when there was a pretty readymade case for a hike in the repo rate - in view of the high inflation and relatively robust GDP growth. The task before it on July 31 is far from straightforward.

WPI (wholesale price index) inflation in the first quarter of 2011-12, at 9.5 per cent, went hand in hand with 8 per cent GDP growth.

The growth momentum, then backed by reasonable IIP growth, stable rupee, strong export demand, robust credit offtake and relatively good FDI and FII flows, waned in the subsequent four quarters.

Average inflation at around 7.5 per cent in the first quarter of 2012-13, coupled with near-stagnant IIP growth in the first two months and a nine-year-low GDP growth in Q4 of 2011-12 at 5.3 per cent, makes it difficult for RBI to choose its path.

For and against Rate cut

On the domestic front, the progress of the South West monsoon has been dissatisfactory. This will keep the already-high prices of food articles under pressure.

A tough stance by RBI on the rate front can be justified on a number of counts: suppressed inflation in view of the possible decontrol of diesel prices, the need to anchor real rates in view of the high inflation numbers so that depositors are not discouraged to save, depreciation of the rupee which amounts to monetary easing, and lack of resolve on part of the Government in reducing subsidies on fuel and fertiliser.

However, weak real sector numbers such as negative export growth, poor credit offtake, anaemic industrial growth and a significant decline in capital goods production for three successive months, makes a strong case for rate easing.

The two key data releases, WPI and IIP, before the July 31 review points to some uptick in growth momentum and continued price pressure in the economy. Given the supply constraints and the Government’s spending on NREGA without commensurate increase in production, we may have to live with higher inflation for some time.

GLOBAL FACTORS

In this context, should RBI be looking at a new normal for inflation — of, say, 6 per cent rather than 5 per cent — and focus on growth? The problem with this approach is that the acceptable level of inflation would turn out to be a shifting target.

In a democracy, it is not prudent to shift the desired level of inflation. Hence, the central bank is rightly averse to such an idea. However, the moot question is, when the central bank cannot do much to combat inflation, should it allow growth prospects to deteriorate by discouraging investment? The central bank should be candid in addressing this issue in its forthcoming review.

With India now a much more open economy, the slowdown is partly on account of the prevailing global uncertainty.

Global Uncertainty

This uncertainty is on account of the Euro Zone. In Europe, recession in a number of countries, and a lack of credible commitment to solving the problems of peripheral countries, will be an impediment to stability.

The fire which had engulfed Greece now seems to be spreading to Spain, Italy and even Germany. The economic outlook for Germany, the strongest euro member, has been downgraded by Moody's from ‘stable’ to ‘negative’ because of the risks arising out of a possible Greek exit from the euro zone and the potential bailouts for Spain and Italy. Going forward, global uncertainty could intensify on account of a fiscal crisis in the US.

The tax concessions permitted in the Bush era are scheduled to be replaced by fiscal compression early next year.

Much would depend on the Presidential elections and the consensus that can be forged between Democrats and Republicans on economic policy.

Implications for India

In view of the global uncertainty, exports growth has been in negative territory for the past three months, and will be subdued for quite some time.

However, the softening of the crude oil prices has come as a major relief for Indian policymakers. This will help reduce the unsustainable current account deficit of 4.2 per cent reported for 2011-12.

Crude oil prices have softened considerably in the past three months, owing to growth concerns in the US, Europe and China. From here on, international prices of crude will depend on the policy response of major central banks to address growth concerns.

A flurry of rate cuts by ECB, Bank of England, and People’s Bank of China in the first week of July, and extension of Operation Twist by the Fed till the end of 2012, suggests that reviving growth is a major priority of central banks the world over.

If global growth momentum picks up, crude prices will escalate, exerting pressure on the import bill.

The issue is whether low crude prices, accompanied by lower global growth prospects, are a better option than high global growth prospects, riding on easy money pumped in by the Fed and the ECB.

The RBI downplayed the impact of global factors in its mid-term review.

With global uncertainty having increased in the past few weeks, RBI can hardly afford to ignore it in its first quarter review.

Apart from domestic macroeconomic situation, the course of action by RBI will be shaped by its assessments of the undercurrents in the global economy and its possible evolution.

(The author is Associate Dean, Xavier Institute of Management, Bhubaneswar. The views are personal.)

(This article was published on July 27, 2012)
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