Abheek Barua: Time to worry about growth?

Further monetary tightening could have severe repercussions later in the year.

Central banks across the world have, over the last few months, sorted themselves into two neat categories. One category led by the US Federal Reserve (the Fed) is more concerned about the prospects of a severe slowdown in their economies than the persistently elevated levels of headline inflation. The other major monetary authority in this club is the British central bank, the Bank of England. Their strategy is to pare interest rates to prevent the slowdown from turning into a full-blown recession.

The second category includes the European Central Bank, which has indicated that inflation gets top priority in monetary management. Thus, not only is it reluctant to pare rates "" it has made it abundantly clear it would not balk at hiking signal rates if price pressures do not come under control. The Reserve Bank of India (the RBI) falls squarely in this "" its agenda has focused on containing inflation by harnessing credit growth and impounding excess liquidity. It hasn't lost sleep over the prospect of moderating growth. In fact, I would think that our monetary top team is quite happy with the visible slowdown in some industry segments like consumer goods and housing where there are concerns of "overheating".

Can these categories remain as watertight in 2008? Perhaps not. Going forward, the inflation "targeters" might just have to dilute their stance and refocus on growth. The RBI, for instance, might just end its tightening cycle in its monetary policy due at the end of January. While it might not go as far as cutting rates, it might shift from a stance marked by extreme hawkishness on inflation to a more neutral mode. It might even consider cutting rates by the middle of the year as the global macroeconomic situation becomes clearer.

My prediction is premised on three things. First, monetary policy is by its very nature forward-looking. It is well established that changes in interest rates impact on the economy with lags that could extend up to two years. Thus, the RBI's decisions in January will have to factor in a view on growth and inflation prospects for the coming year.

Second, it seems fairly certain now that this year will be fairly dismal for global growth. For one, there is a fairly high probability of the US slipping into recession. There is also growing doubt about the ability of other economies, particularly Asia, to de-link from the US. In short, if the US is sliding into a phase of slow growth, it is somewhat insidiously pulling other economies (including India) down with it. This impact is likely to become visible by the second half of the year as export demand shrinks and access to global finance dwindles in response to rising risk-aversion.

I am also reasonably convinced that if global growth were to decelerate, commodity prices are also like to slip. Slower growth has to manifest in a contraction in demand. Even if some of the supply constraints were to persist for some of these commodities (like oil), a downward shift in demand will mean that the markets find their equilibrium at lower prices. As demand concerns begin to surface, the intense speculation that has abetted their price rise is also likely to abate. Oil prices dipped sharply last week as financial markets across the board aggressively priced in the prospects of weaker US and global growth. My sense is that it is the beginning of a trend. A ninety plus dollar price band for oil is somehow incompatible with a negative or barely positive growth rate in US GDP. I won't be surprised if crude prices move all the way down to eighty dollars a barrel in the next couple of months.

Assuming that the RBI's forecasters are thinking on similar lines, the central bank is looking at a possible scenario in which the risks of palpably slower growth outweigh that of a commodity price-driven rise in inflation. The policy solution follows "" hold or pare interest rates.

On the domestic front, the risks to growth are becoming visible. For instance, there appears to be significant moderation in consumer credit that was fuelling prices in segments like housing. Retail credit growth, in our estimates, has dwindled from a peak rate of over 50 per cent in the second half of 2006 to about 16 per cent in December 2007. This has been the key factor in pulling aggregate credit growth down substantially. Since consumption components like housing and durables were driven almost entirely by leveraged expenditure, a slowdown in credit disbursal must imply softness in underlying demand.

Investment demand is still going strong but there are tangible risks. Access to external credit has dwindled on the back of administrative restrictions and diminished risk appetite among global lenders. It would be somewhat naïve to assume that the domestic investment engine will keep chugging along if the international economic and financial environment worsens. High borrowing costs in the face of weak external demand could just push some companies to shelve their capacity expansion plans.

I can see a rationale for the RBI not wishing to cut rates immediately. A hike in retail prices in petrol and diesel seems imperative and were this to happen, headline inflation will perk up. There is some concern about agricultural prices since rainfall in the rabi (winter) crop belt has been inadequate. The "base" effect that has somewhat artificially suppressed inflation numbers is beginning to wear off. Thus holding action is perhaps justified. Further monetary tightening could, however, have severe repercussions for growth in the second half of 2008.

The author is chief economist, HDFC Bank. The views here are personal