At a time when most policymakers are prone to knee-jerk responses to charges of aimlessness — witness the Finance Minister's stout denials of inaction — it is refreshing to see the Reserve Bank of India take decisive steps, however debatable, in the execution of its mandate to combat inflation.

Raising the repo rate by 50 basis points put the FM on the back foot, forcing a reluctant and weak defence of the central bank's position at a time when New Delhi policy pundits would like to believe in the magic of an economic expansion well above 8 per cent.

While the RBI's action is clear and unambiguous, what is not is the justification for the move. The baneful presence of inflation is beyond argument; what is debatable are the causes of its persistence. What the RBI does, in its first quarter review, is to offer a skilful if ingenious taxonomy of inflation that at times almost sounds like a justification for its actions.

When the RBI tells us that inflation has become more “generalised” since May 2010 and particularly after December 2010, shifting its loci from food to non-food, manufactured goods, it introduces a complexity, the ramifications of which go beyond the mere fact of inflation.

CHANGE IN TACK

So far, inflation was considered a cost-push phenomenon, owing its origins and force to supply constraints. Now we hear that its perpetuation over the past seven months is on account of pressures in the manufacturing sector. As the RBI described it: “Non-food manufactured goods inflation persisted at very high levels compared to its historical average and may persist as cost pressures and pricing power remain significant.”

For the central bank the “underlying drivers of the WPI have changed considerably…” Prices since December 2010 reflect the “dominant contribution of non-food manufactured products inflation.” The RBI rounds off by reminding us: “Without the presence of demand pressures the generalisation process (of inflation) would not have sustained over successive months.”

What this does is to add a greater purposiveness to the central bank's war on inflation; so far it seemed a quixotic battle, as supply constraints that caused food prices to rise could hardly be addressed by monetary tightening. It still cannot, but at least now the RBI can take comfort that its weapons will work to dampen demand pressures.

In its monetary review and the subsequent credit policy statement, the central bank admits the rate hikes have had only a marginal effect on the demand pressures and dourly notes they will persist into the second quarter. But the RBI also adds that growth that had already moderated will do so further.

TAKING ON CONSUMPTION

In the bargain, a diagnosis that includes the added disease of demand pressures does something else. It offers us a glimpse into the nature of economic expansion since May 2010. If the RBI's explanation of inflation is right, then the economy has been overheating. The prescription is meant to bring prices down by reducing the pace of growth. When the RBI informs us that growth is moderating and that it will do so right through the second quarter it means that the economy will cool off.

If lending rates move up, then the impact of a tighter monetary policy will be felt well into the second half of the year and beyond, leading to a general reduction in consumption. The RBI prepares the reader for this when it warns that private consumption that has been more robust than investments will now start to slow down.

In a dead-pan sort of way the apex bank warns us that there are “chances of further moderation in investment and consumption as high inflation erodes real consumption and monetary policy actions to restrain demand in the short run work through the system”.

Thus, private final consumption may feel the heat down the road but investments, the other component of GDP has already been singed; aggregate investments declined in the second half of 2010-11 and have not recovered.

INVESTMENT PROSPECTS

The RBI finds that “Corporate investment intentions in projects that received financial assistance dropped by 43 per cent sequentially during the second half of the year.” And why is this? Investments are driven by the power sector, metal and metal products' growth followed by telecommunication; interest rates may have dragged sentiment down a bit, as the RBI admits, but “better implementation can help in improving investment”.

The RBI hastens to add that the government is on the job — some of the long pending legislation, for instance the Land Acquisition Amendment Bill was introduced in Parliament last weekend. But from a diagnostic point of view what the RBI has done is to point a finger at the government for tardy investment growth.

The first quarter review of the RBI thus says a great deal about the economy and government without saying too much. What we can infer from a search for clues is an idea of overheating and a prognosis of slowing investments and consumption in the months to come as it tightens the screws even more to skim off the extra demand pressures.

For New Delhi policymakers, the RBI's review should come as a reality check and force the pruning of growth expectations.

Such an exercise would encourage a closer look behind the GDP numbers at those widening cracks — slack regulatory environment, slowing corporate investments — into which the economy seems to be falling.

>blfeedback@thehindu.co.in

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