Go easy on monetary tightening

The RBI may have already made up its mind on the monetary policy action to be announced on May 3. Be that as it may, I hope it has not been unduly influenced by the monetary hawks, especially those who use the wrong kind of data.

The most commonly used and publicly discussed inflation data is the aggregate wholesale price (WPI) index, measured on a year-on-year (YOY) basis. The aggregate WPI includes the relatively volatile and seasonal fuel and food prices as well as trading margins that are notoriously fickle. Therefore, economists tend to look at the core component of WPI, which excludes food and fuel prices, to get a better perspective on actual inflationary pressures.

THE WORST IS OVER

The world over producer prices that reflect the ex-factory prices (and do not include trading margins) are used to measure inflation. In India, the closest we come to producer prices are the consumer prices for industrial workers (CPI-IW), from which we could exclude the food and fuel components to get a better idea of the underlying inflationary pressures. Moreover, a month-on-month (MOM) measure of inflation, duly de-seasonalised, gives us a forward-looking measure that is more relevant for policymaking.

A look at the MOM rate of growth of WPI shows a rising trend, with the February 2011 increase at 1.12 per cent, or 14.4 per cent annualised. On the other hand, the MOM growth for CPI-IW, which is also high at 1.19 per cent in December 2010, registered low growth in the previous three months and is on a declining trend, having reached 1.96 per cent MOM in January 2010. (All these estimates refer to three-month moving averages.)

Both the WPI and the CPI-IW show not only a similar but worryingly high inflation levels, which according to the hawks, provides sufficient basis to hike interest rates (by as much as 50 basis points), to stay ahead of the curve and squeeze out inflationary expectations.

But the CPI-IW has been on a downward trend, having peaked in December 2009 at 2 per cent. And this downward tendency may well be reinforced if we also take the CPI- rural workers in to account. If retail prices have already peaked and are now declining as reflected in the CPI-IW series, it would not only be unnecessary but, in fact, a serious mistake for the RBI to tighten monetary screws further.

This would engender a sharp slowdown in growth, as was the case in the late 1990s after the interest rates were raised to nearly 12 per cent in 1996. The economy took more than five years to revert to a high growth trajectory. We can least afford such a downward growth spiral at this time, when aspirations are soaring and the pressure of young entrants to the workforce is mounting relentlessly.

ONUS ON GOVERNMENT

It can be argued that we cannot ignore the rise in food and fuel prices. But, as we know, food prices are already declining and the expected bumper rabi harvest will ensure that domestic food prices remain soft despite the global agriculture situation being somewhat uncertain this year. The first monsoon forecast also augurs well for the kharif crop.

We look safe on the food front except for market rigidities. These are eminently amenable to policy correction, like delisting perishables from the APMC schedules that will in one stroke dismantle the oligopolistic cartels that make huge speculative gains from minor supply disruptions. State governments should take this step urgently.

Crude oil prices are now at $120 per barrel and likely to be sticky, given the searing energy demand from large emerging economies like the BRICS group. But a hike in interest rates is unlikely to bring down domestic petroleum demand and prices. Instead, the only way to curb rising hydrocarbon demand is to allow domestic petroleum prices to move in tandem with global prices.

The decontrolled mechanism for petrol must be allowed to function immediately and the subsidy on diesel and cooking gas also eliminated as these are primarily directed at the middle classes and do not benefit the poor. This will help rein in hydrocarbon consumption and more importantly not allow suppressed inflationary pressures in this sector to vitiate prices and resource allocations elsewhere in the economy.

FISCAL CORRECTION

The RBI must, therefore, insist that the government plays its due role in fighting inflation by taking these steps and announcing a further cut in fertiliser and food subsidies. It should not push ahead with the implementation of the Food Security Bill for the time being, as the country does not have the fiscal space to see it through.

A bold announcement for a sharper and quicker reduction in revenue deficit and a smaller public sector borrowing programme will tend to soften market interest rates, which would give a clear signal to investors that the government is prepared to play its due role in achieving macroeconomic stability.

We need to expand capacities in the manufacturing sector and raise investment demand, which is showing signs of slowing down, with the growth in gross fixed capital formation declining to a mere 6 per cent in Q3 of 2010-11, from a healthy 25 per cent in Q1.

The fourth quarter of 2010-11 is expected to show a further decline in capital formation, clearly indicating that investment sentiment is weakening. An interest rate hike would only dampen investment further. Therefore, mere monetary policy action, without the corres- ponding fiscal action, could lead us to a precipitate decline in growth, from which the economy may well take several years to come out.

(The author is Director-General, Ficci. The views are personal. >blfeedback@thehindu.co.in )

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