Policy path forward: Balancing inflation control and growth revival

Despite the growth slowdown, a rate cut-cycle is unlikely to start anytime soon

After a spectacular average gross domestic product (GDP) growth rate of 8 per cent over the last three years, the economy slowed to its weakest growth in seven quarters, registering just 5.4 per cent in the second quarter. While an economic slowdown during the quarter was anticipated, its magnitude exceeded market expectations. Simultaneously, the inflation rate surged past the tolerance level of 6 per cent in October, driven by elevated food prices. 

 

The continued elevation in food prices has started spilling over into core prices. Despite the nudge from political quarters to start the rate reduction cycle, not surprisingly, the Monetary Policy Committee (MPC) focused on its headline inflation target and maintained the status quo on the policy rate. The slow growth in the second quarter raises the question of whether this is merely a blip or structural factors are at play, given the steady decline in the growth rate over successive quarters. With growth in the first half of the current fiscal estimated at just about 6 per cent, and despite expectations of a revival in the next two quarters, the Reserve Bank of India (RBI) has revised its forecast downward to 6.6 per cent from the earlier estimate of 7.2 per cent.

 

The slowing growth and elevated inflation have forced the MPC to continue walking on a razor’s edge. Arresting the decelerating growth warrants starting the rate-reduction cycle and there are nudges in some quarters that the RBI should switch its target from “headline” to “core” inflation. 

 

At the same time, having rightly asserted its commitment to taming headline inflation to 4 per cent, the RBI cannot afford to lower its guard. Not surprisingly, the MPC, in its majority decision, has maintained the status quo on the policy rate while reducing the cash reserve ratio (CRR) by 25 basis points each in two tranches, on December 14 and December 28 respectively, to ensure adequate liquidity. Of course, this is a clear signal that growth considerations are important in its policy stance. This move would ease the tight liquidity conditions arising from tax payments and could help revive growth to supplement the increased government capital expenditures in the remaining two quarters. This is crucial for the revival of investment in manufacturing. All the same, the rate-reduction cycle is not likely to start anytime soon. 

 

The policy response in the current scenario depends on whether the situation is viewed as merely a passing phase or as rooted in deeper malice. The RBI’s policy statement simply describes the situation as an “aberration in growth-inflation trajectory”. There are good reasons to believe that it is indeed so.  However, the sharp deceleration in the value added in the mining and manufacturing sectors, which has pulled down the growth of both the primary and secondary sectors, is a cause for concern. Even the growth in value added in the agricultural sector, at 3.5 per cent on the back of 1.7 per cent growth in the second quarter a year ago and 2 per cent growth in the previous quarter, despite a reasonably good monsoon, is not easy to explain. This may be attributed to the production of vegetables and fruits suffering due to erratic rainfall.

 

Similarly, the deceleration in the growth of the manufacturing sector to 2 per cent in the second quarter is surprising, as the Purchasing Managers’ Index has continued to show expansion during the successive months of the quarter. Even a sector like construction, which showed double-digit growth in the second quarter of last year as well as in the previous quarter, has decelerated to 7.1 per cent.  

 

On the demand side, the slowdown in private consumption could be due to elevated food prices, and government consumption had yet to pick up after the elections. The major factor, however, was the low levels of investment. The gross fixed capital formation registered a growth of just 1.3 per cent, the lowest seen in several quarters, and this was mainly due to the slowdown in public sector capital formation. Both the Union and state governments have delayed incurring capital expenditures after the expiry of the election model code of conduct.

 

Considering the worse than expected growth in the second quarter, most observers have downgraded the growth estimate for the financial year, including the MPC, which has revised it downward. There are reasons to believe that the economy will recover and the estimated growth in the remaining two quarters at 6.8 per cent and 7.2 per cent may well be realised.  The agricultural sector is likely to record higher growth due to the increased arrivals from kharif crops, and with higher reservoir levels, the rabi output is also likely to be better. In the first six months of this financial year, the Union government spent only 37 per cent of the budgeted capital expenditure, and significant spending is expected in the remaining part of the year. This would not only result in an increase in aggregate demand but also “crowd in” private investments. The high-frequency indicators show a recovery in manufacturing. The services sector, too, is expected to continue its growth momentum. 

 

However, it would be too naïve to think that the problem is transitory. Aligning the economy to achieve developed country status would require pushing up the growth of GDP to at least 8 per cent on average for the next 23 years. This would require increasing the investment rate to 40 per cent of GDP from the current level of 31-32 per cent. In addition to opening up the economy for foreign investment, it is necessary to reduce the high cost of borrowing for investors. This requires bringing down the inflation rate to initiate the rate-reduction cycle and implementing fiscal reforms to limit the government’s draft on the borrowing space. Thus, from a long-term perspective, this is the opportune time to undertake fiscal reforms, factor-market reforms with a focus on labour-intensive manufacturing, and open up the economy to greater foreign trade and investment. 

 

Barring unforeseen circumstances, there could be more cheerful news on the inflation front as well, paving the way for a policy rate cut from February.  With better agricultural production, food prices are likely to come down, bringing down the headline inflation numbers. The prices of pulses and edible oils are also likely to soften. Vegetable prices are expected to decline in the winter, and with improved production, the prices of pulses are also likely to ease. With these factors, India may continue to be the fastest-growing large economy, but achieving the aspirational goal of becoming a “Viksit Bharat” requires implementing serious structural reforms. 

 The author is chairman, Karnataka Regional Imbalances Redressal Committee. The views are personal