 "Sonal Varma")
Domestic macro conditions have not changed much in the last six months. The growth recovery remains largely consumption-driven, while private investment is tepid. Consumer Price Index (CPI)-based inflation is close to 6 per cent, while core CPI-based inflation (excluding petrol and diesel) remains in a 5.0-5.5 per cent range. Against this backdrop, the Reserve Bank of India (RBI)'s decision to stand pat is not a surprise.
What is a surprise, though, is how rigid underlying inflation has been, despite favourable global and local shocks. Globally, deflation is a bigger worry amid negative output gaps, falling commodity prices and lower inflation expectations. Domestically, the balance-sheet stress at the corporate and banking system level suggests that disinflationary forces ought to be at work.
Yet, even though inflation has moderated, India still has one of the highest inflation rates in Asia, two full percentage points higher than the average in emerging and developing Asia. Inflation expectations are also elevated, in a 9-10 per cent range.
Elevated inflation suggests one of two things: Stronger demand or severe supply-side bottlenecks. It is true that consumption demand remains relatively robust but aggregate demand is not very strong, or else, it would be reflected in other indicators, such as rising import demand.
Supply bottlenecks are to blame. These constraints are binding in infrastructure and agriculture, which raises the cost of production and hampers the creation of 'one' market. Moreover, without conquering food inflation, on which expectations are formed, bringing aggregate inflation down to 4 per cent, and keeping it there, will be a tough ask.
For a flexible inflation-targeting central bank, the policy path is tied to the inflation outlook. Yet, the wait for inflation to break lower seems to be getting longer. Beyond the base effect-driven fall in headline inflation in December-January, the risks are stacked to the upside.
The upcoming growth triggers — pay hikes and a good monsoon — are geared towards boosting consumption demand, which could stoke inflation. Public capex will enhance the capital stock, which is disinflationary in the medium term but in the short term will support wage growth in the construction industry, creating another source of demand.
Higher rent allowances under the Seventh Pay Commission have been deferred for now, but when implemented could push up CPI-based inflation by 100-150 basis points (bps). Similarly, the goods and services tax (GST) will add another 20-70bps, by our estimates. In all, there is significant upside risk to inflation in 2017-18.
Granted, the GST and pay hikes will have only a transitory effect, but in a high-inflation economy, these need to be closely monitored to avoid any spillover effects. In the early stages of inflation targeting, bringing inflation down is about managing expectations.
India's monetary policy framework has come a long way: The flexible inflation-targeting framework is enshrined in law; a monetary policy committee is being formed and a 4 per cent target set. We cannot throw this away.
Central banks in the developed world may be getting more adventurous with monetary policy, but success is mixed, suggesting that monetary policy is no panacea.
India's growth is currently held back by cyclical factors, but as these fade, the structural foundations currently being laid (as hard as they are) will make for more sustainable growth in future.
Sonal Varma MD and Chief India Economist, Nomura
