RBI has been too hawkish

The Reserve Bank of India (RBI) has continued its policy of monetary tightening in its latest announcement. The Repo rate has been hiked by 25 basis points with corresponding hikes in the other two under the Liquidity Adjustment Facility. One thought of a dovish change in the policy stance reading in between lines in the document on macroeconomic developments issued a day in advance of the policy review.

Thus it says: “Of late, there are signs of aggregate demand softening reflecting a combination of factors including monetary tightening, hindrances to execution of projects and deteriorating business confidence.”

It refers to the declining trend in investment that might affect growth in the next fiscal. Inflation risk, however, persists. In this backdrop, the monetary policy trajectory will need to be guided by the emerging growth-inflation dynamics even as the transmission of the past actions is still unfolding.

I felt that the low level of confidence in the economy revealed by various surveys pointed to a need to rethink the monetary stance. In addition to domestic factors, global factors may slow down growth. Capacity constraints seem to be easing in some manufacturing segments.

Construction activity has slowed. Thus, in my view, the prime objective of the bank to slow down growth to enable the economy to have a soft landing has been achieved, providing a case for a pause in the tightening cycle.

The RBI expects that its policy action and guidance will result in the following three outcomes. First, on the basis of a credible commitment to low and stable inflation, medium-term inflation expectations will remain anchored;

Second, the emerging trajectory of inflation, which is expected to begin to decline in December 2011, will be reinforced; and

Finally, it will contribute to stimulating investment activity. .

I have my doubt only on the last outcome. Having admitted that the rising rates have adversely affected investment activity with the danger that it may spill over to the next fiscal year, how does the bank expect its policy to stimulate it?

The one major concern of the central bank is with reference to fiscal slippages over which it has no control. The rest of the economy cannot be punished with rate hikes to compensate for the excesses of government expenditure. Monetary overshooting is a risk in the face of fiscal pressures. Liquidity conditions remain comfortable and credit growth stays above trajectory. However, real interest rates are still low and supportive of growth.

Management issues

The problem on the price front is to a large extent on the aggregate demand side. The Finance Minister is reported to have said that the current inflation is due to supply constraints. There is no shortage of commodities, be they agricultural or manufactured items or fuel with the exception of coal. Vegetables and fruits that are perishable have done considerable damage on the price front.

The street-side vendor has no facility for preserving them. Despite the handicap, he is able to charge what the traffic can bear. We have established a new record in foodgrains production. The government granaries are overflowing with the food stocks. Still there is not only no decline in the prices of rice, wheat and pulses but there is an increase, albeit being small.

The annual increase in support prices provides the momentum for the phenomenon. Whether it is a high retail margin or a high wholesale price or a high transport cost or high regulated market tariffs needs to be studied to understand the problem.

What is the supply constraint that the FM is talking about? It is basically a reflection of the problem of management.

A correct diagnosis is half the battle won against a disease. The present situation is one where the demand curve has shifted to the right due to higher incomes and dietary preferences in favour of protein items. The consumer is prepared to pay a higher price for the same quantity.

Rural concerns

Inter alia , this is because of the high growth in nominal purchasing power. It is due to the wage-price spiral in urban areas. In the rural areas it is not because of any increased production, but is attributable to the doles paid out in the name of Mahatma Gandhi National Rural Employment Guarantee Scheme.

This is a point I have made ad nauseam in the past, but still it needs to be reiterated for the fear that the government might extend the scheme from 100 days to 200 days in a year before the next slew of elections in big States such as Uttar Pradesh in 2012. Winning these elections in a substantial measure is important for the UPA and the Congress because members of the State Assemblies constitute a half of the electorate for the Presidential election, which will be due in July next year.

Congress would naturally like to see its own candidate in position as President as he would decide on the party or coalition to form government, if the results are not conclusive, after the next general election in 2014 or even earlier. The section on prices is the best in the macro document. It tells us how the price rise in rural areas is higher than in the urban ones. How will the hike in rates solve this problem?

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

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