A losing bout with inflation
With high-inflation expectations and an unceasing march of prices, India is close to a wage-price spiral
Since the new year began, the Indian stock market has fallen 8% below its December peak of 20,509 points. Long bond yields have risen by more than 20 basis points, touching 8.2%. Foreign investors have reduced their weights on Indian investments and capital inflows have turned into a trickle.
Effectively, India stands derated. The persistence of inflation is triggering the rethink. As the feeling that policymakers have no control over inflation gathers force, their macroeconomic stewardship is under question: It didn’t help when the government indicated that usual regulatory measures were ineffective in containing inflation, expressing its helplessness. For these reasons alone, the central bank has to now raise its hand and say “I can”.
There are other reasons, too, for further monetary action. While 36% (3.1 percentage points) of the 8.4% year-on-year rise in the Wholesale Price Index (WPI) in December resulted from food prices, manufacturing inflation accounted for 34% (2.9 percentage points). The persistence in food price inflation, however—a 13.5% increase over December 2009—is now prompting doubters to suspect that strong demand factors could be at play: The prices of vegetables, fruits and other food items are flexible and what if rapid economic growth is also pushing up prices? After all, this year has been nowhere like 2009 when the worst drought in three decades caused temporary supply disruptions. Price spikes due to some vegetable crops harmed by excessive rainfall—which is the case in the last two months of 2010—are temporary and should not be reflected in higher prices of other food items.
Ahead, accelerating commodity prices abroad are a serious risk to core inflation. Some domestic prices—auto and consumer durables— have already risen, following higher input prices; other final prices are likely to follow as margin pressures build up. There’s little spare capacity as utilization levels reached 98% in October, according to a National Council of Applied Economic Research survey. The momentum in bank credit growth indicates strengthening economic activity; the annualized, three-month moving average (deseasonalized) almost doubled to 30.9% between October and December 2010 while year-on-year growth averaged 23% in the same period. Though deposit rates have picked up—deposits grew at 19% year-on-year in December—savers are still getting little returns in real terms. The money multiplier shrank further to 4.8%. The action, therefore, remains in gold and real estate: Bloomberg reported recently that gold imports into India rose to a record high in 2010 and property prices escalated beyond pre-2007 levels in some places.
Public spending continues to be expansionary and it’s unrealistic to expect cuts, given the pattern this year. Even though the fiscal deficit target will be met this year, the inflated nominal gross domestic product (GDP) and tax revenue targets do not fool anybody, nor do the contributions made by one-time, non-tax revenues. The pity is that some of this could have been diverted towards productive investments in agriculture to signal strong determination to tackle food prices; just a beginning— however small—to address the infrastructure deficit and market imperfections in the farm-to-fork supply chain. Such action would be far more credible and effective in quelling inflation expectations instead of periodic assertions that prices will cool in a couple of months. What we have instead is further stimulation through a 17-30% wage hike through indexation of the Mahatma Gandhi National Rural Employment Guarantee Scheme wages to the Consumer Price Index for agricultural labourers.
Unsurprisingly, inflation expectations look set to be entrenched at higher levels, only a step short of triggering a price-wage spiral. The central bank’s own survey for July-September 2010 showed household inflation expectations to rise further—from the current perceived 12.1%—to 12.3% in the next one quarter (Oct-Dec 2010) and to 12.7% one year ahead. Though the Reserve Bank of India (RBI) raised interest rates five times, and cash reserve requirements twice in 2010, nominal GDP grew at 19.5% and 18% in the first two quarters of 2010-11, rendering the policy rate at 6.25%—too low a floor. And real interest rates—the difference between the 10-year bond yield and WPI inflation—again turned negative in December.
It is no surprise that RBI has already signalled an increase in interest rates, asserting its determination to restrain inflation. The rise—largely expected to be 25 basis points—will be accompanied by an upward revision to the central bank’s end-year forecast of 6.0% (6.5 or 7.0%?). Recent comments by RBI governor D. Subbarao that the central bank is desperate to control inflation make one doubt that the hike may be even 50 basis points though the declining momentum in industrial production may offset this. Even so, the average 8.9% GDP growth in the first half of 2010-11 may prompt RBI to revise its growth projections as well.
Later, RBI will also have to take the blame for slowing growth. But then, central banks are always the whipping boys for others.