Look before you repo

Sneha Shankar

The Indian economy needs a mechanism to curtail inflation rates and at the same time give a boost to businesses and in extension, the economy. 

Last Wednesday came as a bit of a surprise to most of us that follow the RBI’s moves. The Raghuram Rajan-led inflation-fighting squad did not increase the repo rate by the 25 basis points it was predicted to. Rajan attributes his move, or a lack thereof, to insufficient data and ‘noise’ in the available set: Given the wide bands of uncertainty surrounding the short term path of inflation from its high current levels, and given the weak state of the economy, the inadvisability of overly reactive policy action, as well as the long lags with which monetary policy works, there is merit in waiting for more data to reduce uncertainty.”

The animadversion to this has been plenty with many bringing to question his hardboiled inflation-fighting reputation.  Increasing repo rates would have been the next logically sound move: it would have increased the cost of borrowing for banks, which in turn would have resulted in an increase in interest rates, and thus reduced spending within the economy. With a pause on market consumption, aggregate demand would have reduced to soothe inflationary pressures. While I agree with these folks to a large extent, they have failed to take into account that we aren’t undergoing just inflation; it’s stagflation – a precarious combination of high inflation, high unemployment, and poor growth. By hiking repo rates right now, the cost of debt for businesses would have increased, only exacerbating growth, resulting in an economic zugzwang.

What the Indian economy needs is a mechanism to curtail inflation rates and at the same time give a boost to businesses and in extension, the economy. Maybe the move was a good, calculated one at that.

How does that work?

Let’s take a look at what’s causing the inflation. The high rates (11.24 percent yoy increase in November) have predominantly been attributed to supply shocks in the food and fuel sectors. The food Consumer Price Index (CPI) has been indicating a month on month increase 1.38 percent from October to November, and increase of 2.42 percent from September, and fuel prices reflect similar rises, having grown from 136.1 in September to 137.5 in November.

This food-price driven inflation could, if the RBI is right, subside with the introduction of the recently-harvested kharif crops into the market, but even that might be being a tad quixotic. CPI data over the past few years doesn’t reflect that. The last time we saw a decline post-November in food CPI was November 2011 to February 2012 (a decline from 113.9 in November to 112.4 in December, but an increase then on to 113.4 in February), but even that reduction was not sufficient to bolster the RBI’s current stand.

Also, there hardly seems to be any evidence to indicate a fall in fuel prices. The CPI in the fuel sector indicated an increase from 136.1 in September to 137.5 in November, despite the fall in petrol prices in both September and October.  Also, interestingly enough, Diesel prices have increased by Re.1 (pre-tax) from September to November, and almost all agricultural equipment run on diesel. There is nothing to indicate the extent of impact that this fuel price hike could have had on the aforementioned inflation in the food sector, but one can’t entirely discount it either. Are there other indications that fuel prices will fall in the near future? None, really, but some hopefuls state that with the Rupee having stabilised, fuel inflation should moderate soon.  But then again, they are hopeful about it, and there seems to be little evidence to corroborate that.

Although everything seems to be pointing at a continued inflation, there is a lack of clarity about the possible outcomes. This was probably the ‘noise’ Rajan was talking about. It could either flip either way, and if they do occur, we do not know if one will offset the other.  On a slightly-off note, many Keynesian analysts have repeatedly stated that this is a supply-side related inflation and tightening the monetary policy would not suffice to address it, but might actually worsen the growth rate.

What about ‘growth’?

Wednesday’s lack of a move, gave the equity market, and businesses in general, a lot to rejoice about. It went a little something like this: By not changing the CRR and the repo rates, businesses that were earlier expecting a more expensive cost of borrowing found that it is now cheaper to borrow than anticipated over the past couple of days. This illusion of a cheaper cost of borrowing has greatly improved business sentiment in the economy, causing most to rejoice and calling this Rajan’s “Christmas gift”. In fact, some banks like SBI, with the same psychological thrust, are reducing home loan rates. This indicates that personal borrowing might also increase. With high liquidity, low CRR, and low IBLR (Inter Bank Lending Rate), this retention of status quo has fuelled credit demand.

So not doing anything has actually done something to boost growth.  But the big, fat concern now is that it results in a surge in the aggregate demand of the economy that could aggravate and contribute to the existing inflationary pressures.

But Rajan and co. claim to be at the ready: “The Reserve Bank will be vigilant… If the expected softening of food inflation does not materialise and translate into a significant reduction in headline inflation in the next round of data releases, or if inflation excluding food and fuel does not fall, the Reserve Bank will act, including on off-policy dates if warranted.”

So what does this mean?

It’s all a waiting game now. Some of it looks promising: Baig and Das, economists at Deutsche Bank, in a note dated December 18, 2013, said “vegetable prices, key driver of inflation in recent months, have started falling in the last couple of weeks (daily prices of 10 food items tracked by us are down by about 7 percent month on month(mom) on an average in the first fortnight of December).”

If the inflationary pressures are cordoned off on the food front, they could be exacerbated by the increase in aggregate demand. But to control that, there are measures in place with the contractionary fiscal policy and a growing trade deficit. The extent of the effects of each can only be concluded over time. For now let’s safely say that Wednesday’s move was not as bad as the online chatter says, and fervently hope the RBI gets rid of the ‘noise’ in the meantime.

Sneha Shankar is a research associate at the Takshashila Institution

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