Dissecting Raghuram Rajan’s First Monetary Policy

As the market begins to factor in the first monetary policy statement by RBI Governor Raghuram Rajan, it is pertinent to look for emergent signals. Let us set aside for a moment the fall in Sensex or Nifty or even reports suggesting RBI intervention in the forex market to prevent the rupee depreciating post policy announcement. We can also leave from our consideration operational easing of CRR maintenance by the banks. What we need to examine is the broader direction the policy stance and the consequent implications for the economy.

Firstly RBI concedes recovery is slow in advanced economies and Fed tapering in the US is just a matter of time. It further accepts that investments are still slow in picking up and places faith in expeditious clearance of investment projects by the Cabinet Committee on Investments. The survey also reports weakening of consumption particularly in the rural belt. The consumer durable goods have been hit hard. A visible signal is the apparent lowering consumer confidence in the rural areas.

Its optimism on moderation in Wholesale Price Index (WPI) stems from easing supply side constraints while the moderation in the Consumer Price Index (CPI) is contingent on the prospects of a robust kharif harvest. It attributes the widening Current Account Deficit (CAD) to lower domestic savings, subdued exports and increased fuel prices (primarily due to geo-political tensions in the Middle East). It also acknowledges the need to focus on inflation and fiscal deficit, what it terms as the primary internal determinants of the Rupee. The statement also accepts a need for a reduction in the cost of financing while containing inflationary pressures.

In the light of the assessment, an examination of key economic indicators would be in order. A slight moderation of CPI is visible (9.52% in Aug ’13 as against 9.64% in Jul ’13 ). On a macro front it is more on account of relative in moderation in increase in rural CPI (8.93% in Aug ’13 as against 9.14% in Jul ’13). This gap is primarily due to vegetable prices (inflation for vegetable commodities stood at 41.93% in urban areas in Aug’13 as against 19.74% in rural areas in the same period).

There has also been hike in prices of eggs fish and meat as also pulses and cereals. Further in the recent years, there has been increasing divergence between the GDP deflator figures (5.8% currently) and inflation measured by CPI. This is being primarily attributed to the dominant presence of food prices in the CPI basket as opposed to GDP deflator (food basket is about 50% of CPI while in deflator, it is about 20%). This divergence has the potential of resulting in policy errors as authoritatively argued here.

The index of industrial production (IIP) in April-July 2013 was -0.2%, while July alone recorded a gain of 2.6%. This gain has been attributed to electrical machinery output increasing by 83% while wearing apparel rose 44%. Yet the consumer durables fell by 9.3%. (A persuasive piece on IIP data is found here).

The Gross Domestic Product (GDP) grew by 4.4% in the first quarter of 2013 fiscal, the slowest in the UPA –II. Both manufacturing and mining and quarrying have recorded negative growth. Data also suggests mining imports has resulted in the increasing CAD. IIP in mining has seen a contraction by 4.5% in the first quarter of fiscal 2013. Production of cement and consumption of finished steel grew by 3% and .2% respectively. This augments the contention that recovery is yet some time off.

In the context of these indicators, it would be interest to note the likely impact of the repo rate being hiked with the accompanying reduction in marginal standing facility (MSF). Theoretically, high interest rates reduce money supply. In the monetary school of thought, inflation and money supply are directly correlated the result being reduced money being purely a monetary phenomenon would supply contains inflation. In fact the US inflation in the early eighties was contained through sustained high interest rates. RBI’s recent policies have been apparently guided by the rising CPI levels and consequent need to curtail money supply.

Further increasing interest rates would have a negative impact on investment and the falling IIP is an indicator of this. Simply put, there is a growth inflation trade off. Inflation as monetary phenomenon rests on premise that there a rise in aggregate demand and aggregate supply is unable to keep pace with it. Thus inflation resulting from demand side pressures could be contained through reduced money supply. Yet the current inflationary pressures seem to be driven by the supply side factors. In an interesting paper in Economic and Political Weekly (EPW) last year, a study of inflationary causes from 2008 onwards suggests a secular trend in increased demand for food is not a cause for inflation nor is the rising import prices. It attributes inflation to supply side constraints. In other words, it is not per se in Aggregate Demand but constraints on the supply side that has resulted in inflationary pressures (More on the article here).

In the current context, if the supply side factors have to improve, two essential things need to be done. Firstly there is a need for monetary easing to pick up investment, consumption and consequently growth. Secondly, inflationary pressures have to be combated through the use of the fiscal space. Currently, RBI seems to be over optimistic about investment clearances by the Cabinet particularly given the track record in the recent past. They are banking on fiscal space for growth while taking on themselves the task to combat inflation. Further in the current scenario, CAD is also on account of high fiscal deficit and increased domestic savings simply cannot substitute it.

Unless structural reforms take place on the fiscal front, the current problems in the economy cannot be wished away. Rajan may have good intentions and capabilities to revive the economy and has probably signaled his independence too, yet he is confronted with certain limitations. Unless the political will, hitherto missing, ensures fiscal reforms, the economics mess may here to stay. Yet given the approaching elections and focus on populist measures, it is unlikely government will bite the reforms bullet. The monetary policy review may well end up as a case of missing the woods for the trees.