Continuing uncertainty about energy and commodity prices may vitiate the investment climate

Inflation is a subject for discussion in the last several months. Even though taming rising inflation and inflationary pressures are concerns of the Reserve Bank of India (RBI), inadequate fiscal measures would derail the goals of the central bank. It is for sure that the forthcoming Annual Policy 2011-12, which would be announced by the RBI in the first week of May, would seriously discuss the issue of inflation.

Demand-side pressures

The issue with inflation today is that it is going to hurt the growth momentum. The first time the central bank admitted that inflation is affecting the growth process was in its mid-quarter review of the policy on March 17, 2011, when it had stated “The underlying inflationary pressures have accentuated, even as risks to growth are emerging.” Rising global commodity prices, particularly oil, is a major contributor to these developments. 

As domestic fuel prices are yet to adjust fully to global prices, risks to inflation remain clearly on the upside, reinforced by the persistence of demand-side pressures as reflected in non-food manufacturing inflation.

This was in continuation to the RBI's views in its third quarter review on January 25, 2011. In its guidance RBI Governor D. Subbarao stated: Current growth and inflation trends clearly warrant that we persist with the anti-inflationary monetary stance. Looking beyond 2010-11, the Reserve Bank had, however, expected that the domestic growth momentum to stabilise and inflation is expected to moderate from the first quarter of 2011-12, while admitting that “several upside risks are already visible.”

In January-end itself, the RBI knew that inflation is clearly the dominant concern. It also stated that “rate itself remains unacceptably high”. There were signs of food and fuel price increases spilling over into generalised inflation. There has been a sharp rise in global commodity prices which has heightened upside risks to domestic inflation.

But it was hopeful on growth rate. Again, in January-end, the RBI pointed out that “growth has moved close to its pre-crisis trajectory even in the face of an uncertain global recovery and the uncertainty with regard to global recovery has reduced.” It found a sound reasoning: The 8.9 per cent gross domestic product (GDP) growth in the first-half of 2010-11 suggests that the economy is operating close to its trend growth rate, powered mainly by domestic factors. The kharif harvest has been good and rabi prospects look promising. Good agricultural growth has boosted rural demand. The export performance in recent months has been encouraging.”

However, after a slight moderation in January, headline wholesale price index (WPI)-based inflation reversed in February 2011 accompanied by a sharp increase in non-food manufactured products inflation. In its Third Quarter Review, the RBI had projected year-on-year WPI inflation for March 2011 at 7 per cent. However, further upside risks have stemmed from high international crude prices, their impact on freely priced petroleum products and the increase in administered coal prices and pick-up in non-food manufactured product prices. In its mid-quarter review on March 17, the RBI revised the March WPI inflation higher at around 8 per cent.

It was a fact that headline inflation has remained above 8 per cent since February 2010. Overall inflation in March stood at 8.98 per cent, much above the Reserve Bank's projection of 8 per cent. Food inflation remained in double digits for greater part of last fiscal. Prime Minister Manmohan Singh repeatedly admitted that inflation, especially of food items, is a matter of concern for the government. In March, the central bank expected that it would be able to rein in demand-side inflationary pressures while minimising risks to growth and manage inflationary expectations and contain the spill-over of food and commodity prices into more generalised inflation.

Earlier, the Central Statistical Organisation (CSO) estimated the GDP growth at 8.6 per cent for 2010-11. While the central bank agreed to this projection in its third quarter review, it warned that continuing uncertainty about energy and commodity prices might vitiate the investment climate, posing a threat to the current growth trajectory. In particular, the weak performance of capital goods in the index of industrial production (IIP) suggested that investment momentum might be slowing down.

GDP forecast

Significantly, prior to the policy announcement of the RBI, a report on India by Goldman Sachs, a leading global investment bank, reduced the GDP growth forecast for 2011-12 to 7.8 per cent from 8.7 per cent due to the impact of higher rates, and a weaker capital expenditure cycle.

It has also raised the inflation forecast for 2011-12 to 7.5 per cent from 6.7 per cent due to the recent large upside surprise in core prices.

It stated that inflation was broad-based with a majority of inflation categories showing increases greater than 10 per cent year-on-year. It also expects the RBI to hike policy rates by another 125 basis points in 2011, significantly higher than market expectations. The investment bank's argument is that real interest rates have actually fallen by about 100 basis points since November 2010, as inflation expectations have risen by 150 basis points, but the repo rate has increased by only 50 basis points.

“Negative real rates, a higher-than-budgeted fiscal deficit, and the need to contain second round effects of the food and energy shocks will keep the central bank in a tightening mode.”

In a recent meeting (April 5) with industrialists RBI Deputy Governor Subir Gokarn observed that after a relatively long phase of benign, growth-friendly macroeconomic conditions, things have begun to look somewhat hostile on the macroeconomic front. The most significant manifestation of this is the acceleration of inflation, a trend that was visible even before the impact of the financial crisis was felt in late 2008, but which very quickly and strongly re-emerged as the economy began to recover in the second-half of 2009-10. Despite significant actions on policy rates and liquidity by the Reserve Bank, inflation remains high, giving rise to some very fundamental questions: is this high rate of inflation, previously believed to be unacceptable, now the new normal? Is it an unavoidable price to pay for sustaining the current growth trend? Or, will it actually work to undermine the sustainability of the current trend?

Vicious circle

Acceptance of a higher rate of inflation as the new normal, an inevitable consequence of rapid growth, will raise risks of accelerating inflation. The challenge for policy-makers is to prevent supply-side inflationary pressures from spilling over into more generalised inflation, both by managing expectations and by reining in demand. This needs to be done with minimal disruption to growth, particularly investment activity. The challenge for the government is to bring down the fiscal deficit, particularly on the revenue account. This needs to be done while ensuring both resource allocation and effective implementation of programmes dealing with critical supply constraints in food and elsewhere. Significantly, both sets of challenges have to be met amidst an uncertain global environment, both generally and with respect to oil prices.

Unlike Finance Minister Pranab Mukherjee, who believes in achieving a high growth rate even at the cost of rising prices, Mr. Gokarn is having a different view: “The issue is not so much one of higher inflation for faster growth in the present. It is about the risks that higher inflation now poses for faster growth in the future. In other words, sustainability of growth over the long-term does require controlling inflation”.

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