Industry performing below potential

After five quarters of expansion, industrial growth is now below the long-term trend, and that means there's room to cut interest rates, say Manoranjan Pattanayak and Vidya Mahambare

The growth rate of the manufacturing sector has picked up over the last three years and it appears that there is a permanent upward shift in manufacturing growth. Is it really the case or are we simply in the expansionary phase of a business cycle? Why is this question important? In the long run, output is determined by the supply of labour, capital and their efficiency. In the short run, however, economic policies, monetary and fiscal, can have an impact on the real economy. Policies operate to minimise cyclical fluctuation. An identification of business cycles that measure the gap between actual and trend growth rate, therefore, is significant from the viewpoint of macroeconomic policymaking.

Notwithstanding that the share of manufacturing in national income has remained constant over the last one-and-a-half decades, growth has picked up since 2003-04. The manufacturing sector has grown faster than GDP since 2004-05 at an annual average rate of 10 per cent. The investment or capital goods sector displayed a robust growth rate of 14 per cent over the last five years. Similarly, the consumer goods sector also grew at 11 per cent over the last three years. The buoyant growth rate of all these sectors conveys a strong confidence of investors in the economy.

Simply put, fluctuations of output above or below their long-run trend levels provide a measure of the business cycle. The trend or the potential output is the level of economic activity that can be sustained, without generating inflationary pressure, given its productivity capacity. In the short run, however, excess demand can drive the level of production beyond long-term potential output. Excess demand in the goods and labour markets causes inflationary pressure to rise. In contrast, if output is lower than the long-term potential, an output slack is formed which, other things being constant, lowers the rate of inflation. Hence, the output gap provides a great deal of information about other key macroeconomic variables such as future inflation, and gives an indication of pressures on the real economy.

Of late, the focus has shifted to the trend growth rate of output rather than the level of output. The business cycle defined in growth terms measures the gap between the actual and the trend rate of growth. The trend growth rate reflects the economy's sustainable speed limit and the gap between the two provides the measure of how the output gap is changing. Policymakers tend to base, or change, their policies depending on how fast the economy is growing relative to its potential. This is because policies try to minimise the volatility of output growth around its trend and maintain the actual output near its trend.

Our estimates for the long-run manufacturing trend growth suggest first, that the growth trajectory of industrial production has moved upwards compared to the late 1990s. On an annual basis, the trend growth rate currently stands at around 9.6 per cent.

Second, a closer inspection of Figure 2 suggests a tapering off of trend output in the recent period along with a rise in volatility. The trend depends on supply side factors such as capital stock, labour use and the available technology. It appears that some of these constraints are now preventing the trend growth to pick up further.

In addition, Figure 2 suggests that the business cycles of the manufacturing sector are rather short-lived, especially so in recent years. In the very beginning of the series, the actual growth is far above the potential growth rate. Subsequently, a cyclical pattern is observed up to 2002-03. After the downturn, which ended in the first quarter of 2002-03, the divergence between actual and potential growth has been abridged, which means we were operating to the strength of our capacity.

However, 2005-06 marked the beginning of a strong expansion phase. When this upturn was in progress, actual growth shot past the potential due to demand-side factors. After the five quarters of expansionary phase starting the first quarter of 2005-06, the boom period has come to an end. The downturn is now in progress, since the last two quarters.

The last upturn of the manufacturing output which began in 2005-06 coincided with GDP growth picking up. Relatively low interest rates during this period is likely to have contributed to increasing demand and sustaining private consumption. Subsequently, interest rates were increased as the monetary policy was tightened to keep a check on inflationary expectations. That has negatively affected the demand for consumer durables and transport equipment. The recent surge in foreign capital flows and the resultant currency appreciation have put further pressure on exports of sectors such as textiles and leather. The cumulative effect of monetary policy tightening is visible in the last two quarters of this fiscal. When the economy grows less than its potential, it has a dampening effect on further price rise. Now that the actual growth is lower than the potential manufacturing trend growth and inflation has moderated, notwithstanding higher inflationary expectations, it provides a reason for a reduction in interest rates.

The third quarter review of monetary policy which was announced on January 29 by the RBI kept all the major policy rates constant at the previous levels amidst a global financial turmoil, and large volatility in the domestic stock market. Further, inflation expectations continue to remain high as world food prices and oil prices continue to be high. The government will sooner or later have to pass over the increase in the oil price to the domestic consumers. When that happens, we may see some increase in inflation.

From the demand side, however, increasing capacity and slowing demand would continue to have a dampening effect on inflation. Although inflation control rightly dominates the RBI's monetary policy agenda, the issue of growth moderation also requires attention. We are likely to see an interest rate cut in the next monetary policy review in April.

The authors are economists with Crisil. Views expressed are personal