India's inflation scene has moved from bad to worse. First, it was food inflation, then non-food primary articles' inflation, then fuel inflation and now, increasingly, more generalized pressures stemming from both the costs and demand sides. In the course of the past 15 months, we have seen non-core inflationary pressures getting translated into core inflation at a faster pace despite ten rounds of rate hikes. Inflation expectations surveys of households by the Reserve Bank of India have been showing worsening of expectations every quarter. This means, consistently high inflation was causing an upward spike in inflationary expectations, which, in turn, were getting incorporated into wage bargaining.
Actually, the recent global economic uncertainties and some early signs of slowdown in the rate sensitive sectors in India had made the task of aggressive tightening quite tough for the RBI. It is certainly laudable that despite this, the RBI showed the strong sense of conviction and raised policy rates aggressively by 50 bps notwithstanding the mounting pressures coming from different lobbies.
Actually, the real dampener to investment sentiment and capital spending is the higher prices of inputs rather than the elevated interest rates. This is strongly borne out by the recent quarterly earnings of companies. Even the corporate demand for new sanctions of term loans has been coming down, as uncertainty about future inflation has been having an adverse impact on the level of planned capital investment.
With today's policy move, the RBI has clearly shown that it prefers the combination of “7.5 per cent GDP growth and 7 per cent inflation” to “8.5 per cent-plus growth and 9 per cent-plus inflation”. The rate action has a strong probability of faster transmission through lending rates given the rising pressure on cost of funds. Moreover, it would encourage banks to appropriately price in the “risks” in loan-pricing, as cost of money has become suddenly much dearer.
Yet, one big puzzle remains to be solved. While demand for the banks' new sanctions has started slowing down, the actual disbursements have in fact increased. For instance, the non-food credit of commercial banks has grown by a robust Rs 1.29 lakh crore in Q1 (2011-12), ignoring the usual seasonal slack in the first quarter of the financial year. Whereas most of the banks have been complaining of a slowdown in the credit off-take, it is a mystery as to which lenders this credit has originated from and which sectors have acquired these funds at supposedly high interest rates.
Having said that, yesterday's monetary policy action shows tremendous courage and credible alertness by India's central monetary authority.
(The writer is Chief Economist, Bank of Baroda)