Recent evidence depicts a worsening growth picture. The slowdown is spread across components. On the consumption side, the trend decline in private and public spending from April 2011 and 2012 is accelerating with fiscal austerity. The weak consumer appetite is visible in the production counterpart; consumer durable goods, for instance, witnessed the biggest-ever fall (21.5% yoy) in over two decades last November. Imports, a key domestic demand indicator, are in double-digit contraction four months in a row and not just from reduced oil and gold demand; minus these, December imports fell 9.5%. Export growth, which slowed to 3.5%, just might portend a fading external stimulus; average export growth in November-December, at 4.7%, is about one-third that in the preceding four months (12.3%). And the last bastion of domestic demand, rural segment, is reported slowing, raising doubts about optimism related to a good monsoon.
This is a vicious spiral of down- trending growth. Even as policymakers are keen to revive investment, monetary and fiscal policies are constrained given high inflation and fiscal imbalance. Looking at the demand scenario and restrictive policies, the question is if investment can take off in such an environment. Something needs to give in to break this spiral. Can monetary policy provide that impulse?
Recall the route to growth unfolded by RBI in October. This, it stated, lay in strengthening foundations of growth by curbing the spiral of rising price pressures, while the revival of stalled projects and pipelines cleared by the Cabinet Committee on Investment would buoy investment and overall activity. A depreciated rupee and monsoon-boosted rural demand would be added stimulus.
Inflation developments are a mixed picture since. The December inflation data released this week confirmed that RBI?s foresight to keep interest rates on hold was well-considered. Both WPI and CPI headline inflation rates eased substantially, 1.29 and 1.36 percentage points to 6.16% and 9.87%, respectively, in December, as vegetable prices corrected sharply. Core-WPI inflation inched up marginally to 2.81% from 2.66% in November, but remains contained within the 3% bound. Core-CPI inflation, on the other hand, remains unmoving from its 8% range.
From a policy perspective, this doesn?t invite a monetary response at this juncture. The puzzle is that inflation which, RBI strongly argued from 2011 onwards, was due to fiscal excesses, refuses to subside notwithstanding sharp fiscal corrections for over a year (since October 2012). One possibility, looking at the difference in WPI-CPI signals, is that the retail price indicator is new. RBI Governor elaborated in his December 23 interviews that the new CPI had a short history, how its components will behave wasn?t known and there was some scepticism about data quality. Understated GDP growth could be another explanation; after all, growth data is often revised upwards and sometimes, e.g., in 2010-11, significantly so. But high frequency information, e.g., low capacity utilisation rates (73.4% as per RBI?s October survey), electricity usage (peak power deficit is down to 4.2% in Apr-Dec 2013 against corresponding 9% in 2012), low non-food credit off-take (14.5%, end-December), high levels of bad and restructured loans reflecting corporate and bank distress, production cutbacks by manufacturers and so on, indicates significant economic weakness. Finally, inflation persistence could be from supply constraints.
The broader macroeconomic slide raises the issue if monetary policy is too tight relative to the economic cycle. Past trends suggest this may be so. For example, July 2006 saw similar headline WPI inflation rate, 6.3%; core-WPI inflation stood at 5.3%; GDP growth was around 9%, and the repo rate was 7%. Or consider early 2003, when GDP growth was likewise weak, about 4%; core-WPI inflation was 3-4% range, headline WPI at about 6%. The repo rate then stood at 7.5% and was adjusted sharply downwards to 6% by January 2004 to address growth. Of course, the WPI-CPI inflation didn?t diverge as much then as now, while core-CPI inflation wasn?t observed. Plus, the current scenario is characterised by a build-up of macroeconomic imbalances, prompting necessary adjustments that are often protracted and can slow down growth.
In such a setting, how realistic is it to expect that project clearances, accelerated as they are the last few months, will translate into realised investments? Projects planned earlier now face falling demand, higher borrowing costs and weaker balance sheets; factors that would render many of these commercially unviable. Political uncertainty and reversal-risks are added concerns. Expecting investments to take off in such an environment could be wishful thinking perhaps.
This brings to fore the grip of inflation control upon monetary policy. The underlying assumption here is that a supply-side response or investment revival, following faster project clearances, will address the demand-supply gap and bring down prices. But such a response could precisely be throttled by an environment of demand-compression from tight monetary and fiscal policies. The circularity needs to be breached, therefore.
It can come from monetary response, given lack of fiscal space and attendant macroeconomic instability risk. In its forthcoming monetary policy review (January 28), RBI could take a lead by analysing these complexities. In particular, the relationship of core-retail inflation vis-?-vis the negative output gap could be more categorical, building upon reservations earlier expressed by the Governor. A clearer articulation on the discordant inflation signals from the CPI and much-older WPI, which corresponds more closely to the state of the real economy, would enable calibrating course that balances inflation risks and at the same time, encourages a supply-side response. For instance, were it not for the elevated CPI-core, an endurance of WPI inflation at current levels justifies signaling a reversal, i.e. a rate cut, in the near future. Without such initiative, the growth roadmap may remain unrealised.
The author is a New Delhi-based macroeconomist
