Invite your attention to the "Debate" column on today's Business Standard.
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The macroeconomic dynamics has shifted from moderate growth; high inflation phase to low growth and moderate inflation scenario. There is consensus in expectation of downtrend in headline inflation into 6.75-7.0% by March 2012 and slippage in growth momentum below 7% in FY13. In concurrence to this expectation, RBI has already shifted its monetary stance from hawkish to neutral in December 2011 policy review; signalled end of rate hike cycle and its preparedness for shift of stance from anti-inflation to pro-growth. The debate now is on the timing of the reversal process. Is it now or later?
While there is comfort on downtrend in inflation; ability to sustain below 7% is in doubt. The strong headwinds are from high commodity prices; weak rupee; supply side concerns and good domestic consumer demand despite tight liquidity and high interest rates. The consumer confidence (and spend) is robust despite fall in investor confidence. The preference for inflation control will stay valid till headline inflation print is above GDP growth momentum and at this stage extension of downtrend in inflation below 7% (into sub 6%) is in doubt. Till this is achieved, it is important to bridge the negative gap between growth and inflation by not allowing the growth momentum slip below 7% in FY13. This brings the focus to liquidity and cost of liquidity. The current situation is worse; draw down from LAF is high above Rs.1.25 Trillion. The system is short of cash by 3% of NDTL against RBI’s comfort level of 1% for over a month. RBI needs to either review its comfort level or pump in rupees into the system. The tight liquidity and high call money rate has kept the short term money market rates at elevated levels while medium to longer tenor rates have adjusted to rate reversal cycle. Clearly, it is important to get the system into adequate liquidity mode at affordable cost as the first measure to shift monetary stance from anti-inflation to pro-growth.
RBI continues to have its concerns (and worry) on sustainability of downtrend in inflation. The headwinds from higher commodity prices and weak rupee are not out of the way driven by weak external cues. While there are serious issues in addressing supply side concerns; further demand pressure on easy monetary regime will add to woes. RBI is left to fight the battle alone in the absence of adequate supportive measures from the Government. The firm grip on hawkish monetary stance can be released soon if Government takes adequate measures to address supply side concerns. On the other hand, significant downside pressures on growth cannot be ignored. The support from external capital; liquidity and consumer demand may not be available through FY13. There is need to build investor confidence on Indian economy to create adequate capacity for expanding supplies. This will need abundant system liquidity and low interest rate regime. While it is tough to balance growth and inflation dynamics in this complex macroeconomic environment, pressure from Governments’ fiscal management is a bother for RBI. Slippage in fiscal deficit will not only lead to higher dependence on the market but lower flow of public investments into core sectors. It would need move into second generation economic reforms to attract foreign long term capital and liquidity into these core sectors. It may not be easy to get political consensus for opening up flood gates for FDI flows.
Most economists and analysts prefer delay in shift into rate reversal mode. While I tend to agree with this on the back of rupee impact on inflation, it seems now that rupee has shifted stance from risk of extended weakness above 54 into extended gains below 51. This sudden change of fortunes for rupee should give good comfort and relief to RBI. There would be good demand for funds in the next couple of months on run into financial year end. There has been higher demand for rupee credit since start of Euro zone crisis. RBI would need to meet this higher demand for rupee funds through CRR cut. But this would not impact operative policy rate while system is already short by 3% of NDTL and call money rate trading at higher end of LAF corridor (Repo rate); CRR cut of 2-3% in one-shot will be needed to bring the operative policy rate to the lower end (Reverse Repo rate) to deliver downward shift of rate curve by 1%. It is not prudent to provide 1% shift in one-shot while it may not be relevant to start the policy reversal process without change in operative policy rate. Therefore, action has to be a combination of CRR and rate cut. RBI has also been vocal in pointing out lag time of 3-6 months to get desired effects from policy moves. Given these macroeconomic and market dynamics, there is strong and prudent case to begin the policy reversal cycle now with “baby step” approach through delivery of 0.5% CRR cut and 0.25% rate cut.
Moses Harding
Head – ALCO and Economic & Market Research
IndusInd Bank, Mumbai
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