Don't slam the brakes

Hiking interest rates

The RBI Governor has recently indicated that, in view of the inflationary pressures building up, India may have to go for tightening of monetary policy before the developed countries do so. This has created apprehension in industry circles that the days of cheap money may be over soon.

But is this the right time for a hike in interest rates in India? Most economists do not think so. Their argument rests on several pillars.

First, it is possible that the Indian economy, despite negative growth in agriculture (due to drought), may yet clock a 6 per cent plus growth rate this year. Though this is a respectable growth rate amidst a global recession, it is still much below the potential growth rate of 8 per cent plus (as indicated by the average growth rate for the latest five years before the slowdown).

There are indications (from recent industrial production and investment data) that the growth engine is gaining speed. So, if the brakes are slammed right now through increase in interest rates and reduction in liquidity, the economy may lose its momentum and it would be forced to grow much below its potential.

Further, the government of India cannot afford to run the huge fiscal deficits which it is doing now to combat the effects of global recession and drought on the Indian economy. If monetary tightening takes place along with fiscal contraction, the adverse effects on growth would be even stronger.

Second, even if there are some early signs of the developed western economies coming out of recession, there is considerable uncertainty about its durability. The private households, in particular, have suffered a huge wealth destruction caused by the fall in home and stock prices. Now they are desperately trying to build up assets by cutting down their consumption expenditures.

Since the turnaround in unemployment rate lags behind the turnaround in GDP growth rate, the fear of jobless growth is still very real in the US and Europe. This is further restraining consumption expenditures as unemployed  people are in no position to spend.

In addition, a significant part of the recovery is due to the huge stimulus packages thrown in by governments. It is not clear what would happen when the stimulus funds are gradually withdrawn by the governments in such countries which they will have to do to bring fiscal deficits to sustainable levels.

Exports vital

Despite talk of a ‘decoupling effect’ (meaning that the Asian economies today are much less dependent on western economies for exports and growth), a full recovery in economies like India cannot take place without the export growth rate reaching their pre-recession levels. But that may take a couple of years.

Third, the nature of the current inflation. According to WPI, the inflation rate is just above zero. By CPI measure, the inflation is in double digits. This is because the sharp rise in prices is mostly restricted to food items like rice, sugar, pulses and vegetables. In other words, the high inflation (CPI) is primarily due to sector-specific supply side factors getting worse by the drought. Since there is no general excess demand problem, the tight money policy will be ineffective to contain it.

On the contrary, restrictive monetary policy, by raising the interest cost of production and distribution operations, may increase the prices further. The measures needed to tackle the current inflation have to be supply side initiatives like offloading from buffer stocks and imports and discouraging hoarding of commodities by selective credit controls.
Fourth, the growth rate in non-food credit is still much below the pre-slowdown rate. So, there is no evidence of an excessive money supply growth in the economy.

Finally, for some time following the onset of the global financial crisis, the US dollar was steadily rising against the Indian rupee as investors and central banks were switching to the US dollar, the safe haven asset in times of global turmoil. Now that the situation has stabilised, investors are coming back to emerging markets like India.
As a result of massive capital inflows, the rupee has now started to appreciate. This would adversely affect the export industries and would have a negative impact on the growth rate. If RBI raises interest rates at this juncture, it would further encourage funds to flow to India in search of higher returns, causing further appreciation of the rupee and depressing the growth rate.

So, all considered, a general tightening of monetary policy is not the right option at this point of time. The RBI will have to keep its monetary policy (interest rates and supply of credit) tilted in favour of growth for some more time in the game of growth-inflation trade-off.

(The writer is a former professor of economics at IIM, Calcutta)