The Reserve Bank of India continued with its most explicit policy priority to rein in rising prices — to contain the demand-driven component of inflation, spill-over risks, and inflationary expectations.

The central bank's rate hike decision last Friday — the 12{+t}{+h} in last the 18 months — has taken the repo rate to 8.25 per cent, closer to the peak of 2008. Policy rates, in effect, were hiked by 500 basis points since March 2010 — first, in calibrated “baby-steps” throughout 2010-11, but often with a markedly greater vengeance in more recent months.

Indian economy is going through troubled times. Inflation stays stubborn — the headline hovering near double-digits now for almost two years and will possibly remain so for the bulk of 2011 amidst wide-spread pressures across food, energy and manufacturing prices.

inflation management

Of late, the RBI has repeatedly vouched for its anti-inflation commitment, even at the cost of sacrificing near-term growth, if needed. The stern anti-inflation stance remained unmistakable even in the latest policy statement. It is unlikely that a further near-term slowdown in growth will deter it from remaining hawkish if the inflation dynamics demands so. Going into the September policy, another key concern was whether the worsening global situation would persuade the RBI to hold rates steady. The RBI made it explicit that it stays watchful of the global situation, but prefers to accord priority to domestic developments at this juncture.

Growth settling below trend

Liquidity had also been kept under a tight leash since mid-2010. While the effect of the RBI tightening on banks' interest rates had, at the most, been modest till late-2010, there had been a sharp up move in lending rates afterwards. India's growth is primarily domestic-demand centric and the tight liquidity, higher interest rate combination is turning out to be mighty challenging for several sectors such as manufacturing, construction, real estate, banking and finance, and for a large number of SMEs across sectors. Credit growth can potentially go down to mid-teens in 2011-12 in contrast to an average of 20 per cent in recent years. Business sentiment has turned distinctly subdued as growth trajectory is clearly settling below its trend level.

Peaking of the rate cycle

In the coming months, the unfolding moderation in credit, investments and GDP growth would likely influence the RBI to gradually tone down its hawkishness, unless we see any fresh unforeseen inflation shock. While headline inflation prints may still rule high for an extended period, going ahead, the key should be the contribution of domestic demand (to inflation), only which a central bank can aspire to contain effectively. On balance, the RBI can be expected to gradually settle for the pause mode in the coming months. From the latest statement, however, another hike in the October policy cannot be ruled out.

Lot more deep-rooted

The inflation print, on a convenient year-on-year basis, will likely start heading down from early-2012 and reversal of the interest rate trajectory can well be next summer's theme. Nevertheless, it would not offer any relief from several uncomfortable broader issues. Clearly, inflation in India is lot more deep-rooted and it can be naive even to aspire containing it just with aggressive use of cyclical policy tools like the central bank repo rate.

Rate hikes, after all, are not costless. In terms of surface-level macro analysis, it is a loss of growth merely by few basis points. The perils of high inflation or sudden loss of growth momentum for the weaker sections of the economy such as the SMEs and the unorganised sector can be far beyond the realm of just an aggregative macro figure. It is severely disruptive to the longer-term development aspirations of the nation as well.

There are several structural issues here. We have created huge wealth effect over a decade with explosion in a number of asset classes, ranging from the equity market to land property. On the rural front, developments in infrastructure (for example, irrigation, storage, agro-research) remain far from being adequate. Per capita food grain production in India is static, if not falling. Problems of hoarding, black-marketing and distribution inefficiencies remain perpetual. It is important to question ourselves why food inflation would hit 20 per cent in a decent crop year like 2010. In case of industry also, the recent experience around expansion endeavours had often been murky and demands far greater policy support.

Essentially, there is no conflict between inflation and growth. The long-term response to inflation management needs to be by enabling and alleviating supply in the economy and not by hiding behind the relative convenience of managing near-term demand.

(The author is Director and Chief India Economist, Barclays Capital.)

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