The argument that monetary policy measures have limited impact on inflation caused by supply side factors is valid to a large extent.

The base effect that artificially depressed inflation figures during the first half has now started working in the opposite direction

Ahead of the Reserve Bank of India’s third quarter review of the monetary policy on January 29, it is worth taking stock of the major issues that will engage the central bank. The traditional policy dilemma of maintaining growth or reining in inflation has acquired a particularly sharp edge this time.

Data released recently point to a rise in overall inflation. Not only have food prices remained high, the monthly WPI inflation at 7.31 per cent in December is well above the RBI’s target range of 6-6.5 per cent for the whole year. Food inflation data, now released at weekly intervals, continue to present a grim picture. Though down from its December peak of 19.17 per cent, it still remains very high posing grave challenges for policymakers. High food prices have naturally become a sensitive issue politically.

Inflation fears

Higher inflation during the second half of 2009-10 was anticipated. The base effect that artificially depressed inflation figures during the first half has now started working in the opposite direction. Equally significant, delayed monsoons and drought followed by floods in different parts of the country have had an adverse impact on the autumn food crop.

Rice production is estimated to be 10 million tonnes lower this year. The expectation from the rabi (winter) crop has correspondingly increased. That along with high global petroleum prices bodes ill for the management of inflation expectations. Already there have been reports suggesting an imminent hike in the retail prices of petrol and diesel.

While that has not happened so far, the expectation is that the government will be forced to increase the administered prices soon. The burden of high oil prices will be felt on the economy, whether the consumers bear its brunt or not. Oil companies may have to be compensated more. The fiscal deficit, already high, will go up further.

Supply side problem

The argument that monetary policy measures have limited impact on inflation caused by supply side factors is valid to a large extent. The current bout of inflation can be countered only by increasing the supply of food and other essential articles. Both the government and the RBI hold this view.

So far, at least the RBI has not used its monetary weapons to curb inflation. But even supply side issues may aggravate the demand side factors. High food and petroleum prices may harden inflation expectations.

Besides, there will be second order effects from inflation that will spill into the demand side, forcing RBI intervention. There could be a demand for wage increases, for instance.

RBI’s guarded stance

The satisfactory growth story heightens the central bank’s dilemma. By the end of last year there were expectations that India’s GDP growth would bounce back to an annualised 8 per cent level over the medium-term.

There has been a steady acceleration in the growth momentum. Almost all forecasters have been revising their estimates upwards. A rate of 7 per cent for 2009-10 seems attainable.

The RBI, however, has been conservative so far and has not revised its estimate of 6 per cent with an upward bias. Even the CSO’s (Central Statistical Organisation) announcement of a spectacular 7.9 per cent growth in the second quarter (July-September 2009) has not made the RBI change its projection. Most likely, the forthcoming policy statement will be more upbeat.

Industrial pick-up

One of the more positive reports on the economy has been the recovery in industrial output. The Index of Industrial Production grew in November by 11.7 per cent over a comparable period last year. The cumulative growth over an eight-month period (April-November) has been 7.6 per cent. The data showed a revival in consumer spending.

A faster rate of growth will accentuate the policy dilemma of growth versus inflation. A surfeit of liquidity in the system — banks are placing with the RBI about Rs.90,000 crore of surplus money everyday — probably requires RBI intervention. Most likely it will be in the form of a modest hike in the cash reserve ratio for impounding surplus liquidity. Signalling higher interest rates through the repo and reverse repo rates may not happen in the first instance, according to many analysts.

Credit offtake in any case has been modest this year — by 12 per cent or so against a target of 20 per cent.

The question of RBI moving away from its extremely soft stance adopted since September 2008 (after the Lehman Brothers collapse) is a topical issue that obviously overlaps with the traditional policy dilemma, namely, growth versus inflation. Already, since September last year, the RBI has been slowly reversing its stance by restoring the SLR, the percentage of deposits banks need to invest in approved government securities. Will the forthcoming policy signal a more accelerated reversal?

Keywords: Monetary policyRBIGDP