Pause in rate hikes is in order

As the Reserve bank of India (RBI) formulates its review of monetary policy, it faces, as in the past, a number of paradoxes, both on the international and domestic fronts. The US and Europe are still mired in the after-effects of the international financial crisis; this time it is even deeper.

Conventional and received wisdom in policymaking haven't helped much in the West, as it has been the case in Japan for nearly two decades. Out-of-the box thinking has been suggested by experts. But what more can, say, the US Fed, do to stimulate the economy short of engaging helicopters to drop dollars all over the country? It has had two massive Quantitative Easing (QE) policies but growth is still in decimal points, while unemployment is stubborn at 9 per cent.

PARADOXES APLENTY

The situation is similar in Europe, too. The downgrading of the rating of the US has led to capital inflows to that country instead of outflows! Obviously, the saying that a known devil is preferable to an unknown angel holds good in the psychology of nations as well. The yields are negative in real terms, be it the government or corporate bonds. The problem is that markets haven't been kind in recent weeks to those fund managers who have taken the plunge.

Worries regarding the strength of the global economy have caused investors to sell riskier assets, and prefer the safety of government bonds. Round-tripping of created money to the central bank is the prevailing mode. Banks have built up massive excess reserves in the US, adding up to more than $1 trillion, undoing the effects of QE. Under the circumstances, there is no great likelihood of funds of foreign institutional investors (FIIs) flowing in large quantities to India in the near future, to take advantage of the interest rate differentials.

On the domestic side, the paradox is that despite a reasonably good monsoon, and improvement in supplies, food inflation remains stuck at around 9 per cent. Earlier, we were told that it was only a supply-side problem; later it was admitted by official agencies that it was both a demand and supply problem. Inter alia, the additional incomes generated by the Mahatma Gandhi National Rural Employment Guarantee Scheme, without any commensurate benefit to the country in terms of output, have added to aggregate demand and aggravated inflation. It is a case of a shift in the demand curve while there is no marked change in the supply curve. The one silver lining is the double-digit growth rate of exports, thanks to diversification in their destinations.

WHAT LIES AHEAD

As has been well-pointed-out by the Reserve Bank of India in the recent period, it cannot bear the burden of fiscal policy and take compensatory action to correct the expenditure excesses of government. There are lags in the impact of policies on the economy, and their distribution during a period of time has been the subject of considerable research since the days of Marc Nerlove, now a Professor of Economics at the University of Maryland.

It would appear that the total impact of the lags could be experienced anywhere between 18 and 30 months. The rollback of the stimulus measures had to be undertaken by the central bank even before the full effects of the massive expansion of liquidity in 2008-09 had worked themselves out.

The persistence of inflation is in its residual effect. It is a measure of the steep increase in the prices of protein items, that they have come to exercise a strong influence on the headline inflation despite their low weights. Likewise, it is a case of the tail of vegetable and fruit prices wagging the dog of overall inflation.

There is a ‘Thursday Terror' for the authorities every week when data on inflation, in respect of food articles, are released. It hasn't come down below 9 per cent. It may be expected to remain at elevated levels till March which, according the seasonal indices of the RBI, marks the trough, subject to the caveat that prices are determined not only by seasonal factors but also cyclical and random elements. Since the RBI has done enough on the monetary front, it can afford a pause in further tightening until the next review to allow the lagged effects to work out fully.

The slowing down of growth for a soft landing of the economy has been realised in the battle against inflation and the central bank won't like to see any further fall. The proposed increase in government borrowings to the extent of Rs 53,000 crore will strain the liquidity situation, especially during times when advance tax payments are due. The pause in tightening may provide some relief to the government borrowing programme, which has seen heavy devolvement on primary dealers.

The RBI may have to undertake Debt Management Operations by buying old securities in the market in order to pump in liquidity to facilitate subscriptions to new bonds. It would tantamount to monetising public debt. In that context, the central bank may have to give thought on further measures later.

(The author is a Mumbai-based economic consultant.)

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