Monetary policy: Hawkish stance unlikely to promote growth or tame inflation

As was widely expected, the Reserve Bank of India’s (RBI) Monetary Policy Committee (MPC) decided on June 8 to increase its benchmark policy rate — the rate at which it lends to banks and which sets the floor rate for interest rates in the economy — to 4.9 per cent. The move, which has effectively pushed up interest rates by 90 basis points (bps) — a basis point is one-hundredth of a percentage point — in a matter of weeks, effectively reverses the central bank’s “accommodative” stance that commenced in the wake of the pandemic in early 2020.

Although the move confirms that the RBI has, albeit belatedly,  recognised that the prolonged surge of inflation can no longer be termed “transitory” in nature, there is worry that the hike in interest rates would quell the already weak prospects of an early economic recovery, while doing little to counter inflation. The question to ask is this: Is the RBI wielding a sledgehammer against inflation, unmindful that it may well smash all possibilities of economic growth?

Also read: RBI hikes repo rate yet again, this time by 50 bps to 4.9%

Just two months ago, in April, the central bank had forecast inflation in the current fiscal year to be 5.7 per cent. This has been revised upwards to 6.7 per cent, effectively conceding that it is beyond the outer boundary of its “tolerance” band. The MPC forecasts that inflation, as measured by the Consumer Price Index (CPI),  will remain at heightened levels in the April-June quarter, moderate marginally in the succeeding quarter, and then reduce to a little over 6 per cent in the September-December quarter. The central bank’s forecast needs to be treated with some scepticism for several reasons.

The nature of inflation

The first reason pertains to food prices, the classic wage good in the economy. Following the rather poor wheat harvest this year, and the collapse of public procurement of wheat, there is little available with the government for what is termed as Open Market Operations (OMO). These operations, which allow wheat to be released to quell prices in the market, are by no means insignificant. Last year, about 6 per cent of the rabi wheat crop was sold by agencies like the Food Corporation of India. This year, because of the collapse of public procurement, there is no such cushion available with the government.

Quite apart from the fact that wheat goes into the making of a wide range of food products, the necessity to substitute wheat with rice, because of its shortage this year, would have the effect of pushing up rice prices, too, during the course of the year. The prices of other food products, such as edible oil, are also likely to go up because of not just the limited availability in global markets but also because the cost of imports has risen significantly as a result of the steady depreciation of the rupee.

The second feature of the inflationary situation pertains to the obsession with inflation as measured by the CPI, while ignoring producer prices, as measured by the Wholesale Price Index (WPI). It is significant that while popular attention has been largely focussed on the spectacular surge in petroleum and food prices, the prices of a whole range of intermediate products, raw materials and inputs has been increasing sharply over the past year. And, it shows no signs of abating. 

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Indeed, the latest data on wholesale prices (for April) shows that prices have been galloping at more than 15 per cent. Wholesale prices have been growing at double-digit rates for 13 months now, rendering utterly vacuous the notion that they are “transitory” in any way.

Widening gap between wholesale, retail prices

There could be only two plausible explanations for the wide gap between prices measured by the consumer index and that pertaining to producers. The gap could arise simply because the transmission of prices from wholesale to retail levels are missed because of the way the indices are constructed. 

Or, if this is not the case, the gap arises because producers are now unable to pass on price increases to consumers because they worry about weak demand. Recent anecdotal evidence about the conduct of FMCG companies, that they prefer to reduce pack sizes — implying higher unit costs for consumers — instead of increasing prices that would fully account for the increase in their input costs, suggests that companies worry about weak demand.

Also read: As inflation spikes to 8-year high, Indians see package ‘shrinkflation’

The sharp and incessant increase in the price of steel, cement, base metals, fertilisers and a whole host of intermediate goods that enter into the production of other goods, implies that there are limits to how much companies and other economic agents can internalise these price increases without passing them on to customers. 

In fact, it is instructive that the price surge that happened immediately after the opening up of the economy after the first lockdown resulted in companies’ profits increasing dramatically. This was because companies could pass on the higher costs to consumers at a time when “pent-up demand” was released. The current situation appears to be very different because demand has all but evaporated.

Economists generally agree that interest rate hikes have little influence on inflation if the underlying impetus to prices is from the supply side, And, there is plenty of evidence to suggest the impetus to the current surge in inflation — from crude oil to food to the prices of a host of industrial intermediates — is arising from the supply side.

The logic of hiking interest rates

Interest rates, the key instrument in the monetary policy tool kit, are in theory supposed to work by quelling demand. And, since price stability is the key objective of not just the RBI but most modern central banks, the instrument’s effectiveness rests on the perception that the economy is “overheated”. 

Also read: RBI has struck right inflation-growth balance, say experts

According to this logic, since surging demand, relative to supply, is the primary cause of inflation, curtailing demand through a reduction in the pace of economic activity via an increase in interest rates would keep prices in check. This logic, however,  does not sit well with the empirical reality in India. 

The latest estimates of national income released by the National Statistical Office (NSO) on May 31 confirm that India is indeed going through a demand compression. The Private Final Consumption Expenditure (PFCE), the closest approximation of the level of demand in the economy, was just 1.44 per cent higher in 2021-22, when compared to two years earlier — an increase of just about 0.7 per cent in annualised terms. 

The fact that the PFCE accounts for almost 60 per cent of the overall Gross Domestic Product implies that stagnant demand is indeed a big deal. Moreover, the fact that the PFCE increased at an annual rate of just over 2 per cent since 2018-19 implies that the slowdown in consumption predates the pandemic and that there is an urgent need to revive demand in the economy.

Examining the other major slice of the national GDP, which pertains to capital formation, provides a picture of what is happening to investment, a key driver of growth via capacity creation in the economy. Although the Gross Fixed Capital Formation (GFCF) increased by about 15 per cent in 2021-22, this apparently spectacular increase arises from a statistical illusion — what is referred to in statistics as a base effect problem.

Indeed, the apparently sharp increase in 2021-22 may well have been in projects that were abandoned in the pandemic, but resumed later. In reality, the GFCF in 2021-22 was just 3.75 per cent higher than that in 2019-20 — an annual increase of less than 2 per cent.

Given that interest rate hikes have an economy-wide impact, leaving no scope for targeted intervention by the central bank, they are likely to damage prospects of a recovery in sectors that have a crucial impact on employment, incomes and output. The latest estimates of national income reveal that three key sectors — manufacturing, trade and construction — which together account for about 44 per cent of Gross Value Added (GVA) in the economy, have slowed down significantly in the last few years.

It is noteworthy that the performance of all three sectors have a significant impact on employment, incomes and output. While GVA emanating in manufacturing has grown at just about 2 per cent per annum over the past couple of years, GVA in the category comprising trade, hotels and other services actually declined by 6 per cent when compared to 2018-19, well before the onset of the pandemic. The latter, which has been particularly hard-hit since the pandemic, is characterised by low wages, informal terms of employment, but is highly labour intensive.

Economic recovery in jeopardy

The RBI’s action in front-loading interest rate hikes — with more hikes on the anvil later in the year — indicates that it has brought inflation-targeting centerstage. But in the process, it threatens to derail whatever little hope there was for growth.

There is another aspect of the rate hike, which is missed out in most commentary. This pertains to the differential impact the rate hikes would have on different economic agents. It is well known that during the prolonged period of “accommodation” in which the repo rate was pegged low, large conglomerates unwound their debt positions, taking advantage of the low interest rates. However, smaller units and businesses, badly hit in the pandemic, were unable to take advantage of this. 

Now, as interest rates rise, and threaten to rise even higher in the months ahead, they would find the situation difficult. Forget capital for fresh investments in capacity, they may have to pay much more for sourcing their working capital needs. All this points to the perpetuation of what several economists have termed the K-shaped recovery in India, characterised by a differential pace in recovery, depending on the size and scale of businesses.

The RBI’s hand may well have been forced by what other central banks have been doing, or have been threatening to do, in the wake of the surge in inflation. After all, in the context of globalisation, it cannot afford to let interest rates in India be out of sync with those in other major markets; that would only invite opportunities for arbitrage and a further depreciation of the rupee.

It may well turn out that the RBI’s obsessive focus on interest rates will result in neither quelling prices nor promoting growth. The RBI may well have run out of options, but what explains the government surrendering all responsibility for a recovery to the central bank, which has only limited room for manoeuvre?

(The author, a senior journalist, is a member of the People’s Commission on Public Sector and Public Services)

(The Federal seeks to present views and opinions from all sides of the spectrum. The information, ideas or opinions in the articles are of the author and do not necessarily reflect the views of The Federal)