When the Reserve Bank of India meets on Friday to take a decision on whether or not to hike interest rates, inflation will be its key focus given the more-than-expected increase in the Wholesale Price Index in August.
But the slowing pace of economic growth and the worsening global economic outlook will also be important inputs in its decision-making.
Overall, activity indicators suggest that growth is moderating as desired by policymakers, but inflation also remains unacceptably high at 9.8 percent as the August data shows.
Much has been made of the recently announced industrial production data for July, where growth was below expectation at 3.3 percent year on year. As has been the case in recent months, industrial production data doesn’t give a reliable picture of the ongoing economic activity, partly due to the excessive volatility in the capital goods segment.
Just as June’s above-forecast industrial production growth of 8.8 percent year on year did not signal any pickup in industrial activity, the latest July data also does not suggest a more dramatic downshift than what was already assumed before the data came out. Indeed, the output of capital goods, which had surged 38.2 percent year on year in June, reversed to post a decline of 15.2 percent in July.
The ongoing moderation in economic activity is not new and is going to gain more traction. Overall, the industrial production data exaggerates the pace of deceleration. But growth deceleration is precisely what monetary tightening is meant to achieve in order to check inflation, although the government’s policy paralysis in terms of reforms and supply-side initiatives also has a role to play in this deceleration. There is a strong possibility that India’s GDP growth for the year ending March 31 2012 will be in the 7-7.5 percent range, lower than the RBI’s guidance of 8 percent.
India’s inflationary pressures are a complex mix of demand- and supply-side factors that cover food and non-food categories, and are structural and cyclical in nature. Global commodity prices have been a key driver of inflationary pressures in the current cycle. However, it is often mistakenly assumed that inflation is driven only by cyclical demand pressures that higher interest rates will be able to check.
The strength of aggregate demand, especially in the absence of the much-needed reduction in the fiscal deficit, is a relevant contributor to inflation. However, it is often overlooked that inflation is also an outcome of government policy initiatives designed to improve terms of trade for the agriculture sector, via higher minimum crop prices at the expense of the rest of India, broadly the urban middle-class.
The RBI probably does not rely significantly on the industrial production data given the recent high volatility. Its main focus will remain on checking inflation and hence another rate hike is justified. No central bank can deliver low inflation with high growth when the government is unable to push ahead with meaningful actions to check the supply-side factors to lower food inflation and eliminate structural rigidities.
In the absence of effective steps from the government, at least one more rate hike is called for, unless the RBI disappointingly succumbs to external pressures from politicians and industry lobbyists.
Rajeev Malik is Senior Economist at CLSA, Singapore. He is a regular guest on CNBC TV. The views expressed in this article are his own.