Maya Bhandari on India's Reserve Bank of Stagflation

Read more at India- An Examination of another Emerging “Miracle”

The Reserve Bank of Stagflation

The collapse of world trade in late 2008 drove brutal recessions for big exporting countries, most spectacularly China, Japan and Germany. But India, largely driven by domestic demand, emerged relatively unscathed. Gross domestic product shrank in the final quarter of 2008, but only by 0.2%. At its lowest point, industrial production dipped 2% below the pre-crisis peak, the best performance of all major economies, and has since bounced back powerfully to well above the mid-2008 peaks. Yet the combination of a lethargic central bank and swelling inflation could now quickly alter this seemingly benign scenario.
This may seem counterintuitive. India’s Reserve Bank raised two of its four main policy levers—the repo and reverse repo rates at which the central bank lends to and borrows from banks—by 0.25 percentage points and 0.50 percentage points respectively at its meeting last week. The more powerful tool, the ratio of cash reserves banks must keep at the central bank, was left unchanged.

Notwithstanding a warm reception from markets and commentators, these latest policy “moves” were in fact little more than token gestures. The two most relevant rates, the repo and cash reserve ratio, are still considerably below where they were before the central bank misguidedly started slashing interest rates in the fourth quarter of 2008. While the cuts back then, by 4.25 percentage points and 4 percentage points respectively, appeared to conform to what other central banks were doing at the time, they may have had as much to do with the run-up to general elections in May 2009. The ruling Congress Party benefited from cheap credit before voters went to the polls.
At best, the new higher rates might convince banks to hold less excessive quotas of government paper on their balance sheets: More than 40% of banks’ assets (measured as total loans) are held in government bonds. Meanwhile, raising the “tolerable” wholesale price inflation rate to 6%, from 5.5% in April and 4% a couple of years ago, is a grossly inefficient way to manage the problem. (Among other variables, India’s central bank “targets” wholesale price inflation, which is also heavily influenced by the exchange rate.)
But these measures are unlikely to be anywhere near enough. It is clear that India has a large and growing inflation problem. Prices are rising at anywhere between the 10.5% on the wholesale price inflation measure and 14.5% on the rural consumer-price measure, considerably higher than inflation rates of the five years preceding the crisis, a period commonly known as the “Goldilocks years.” The result has been heavily negative real, or inflation-adjusted, interest rates. Depending on which data one chooses, real rates are between minus 5% and minus 8%, and even that may be an understatement.
All inflation measures are poised to accelerate further. Primary articles inflation, for instance, leads other inflation rates—as it is released weekly rather monthly, and comprises chiefly food in most indices—is running at more than 15% in annual terms. At current levels, Indian inflation is also not far from British inflation just before and after the bitter stagflation years of the late 1970s and early 1980s, with a substantially more central role for domestic demand in India’s case.
These price trends are unsurprising, given ultra-loose monetary and fiscal policies, an overheated economy and large-scale debt monetization by the government, which was highly inflationary.
But what is surprising is the central bank’s meek reaction, particularly given the hawkish tone of its own statement last week, which acknowledges that inflationary pressures have become “exacerbated” and “generalized, with demand side pressures clearly evident.” The statement warned that wholesale price inflation would likely trend higher. And the bank concluded that “real policy rates are not consistent with the strong growth that the economy is witnessing . . . (and that) it is imperative that we continue to normalize our policy.”
In short, the central bank has fallen badly behind the curve. Having administered huge doses of unnecessary policy stimulus, it has been lethargic in its withdrawal. Political pressure probably explains why it is raising rates at this stage in the cycle—the government wants to get this phase over with before they have to face more elections.

The chief concern from here onward is that aggressive policy action will coincide with the worst point in the economic cycle. Consumer spending is both the major component and growth driver of the Indian economy, and the first quarter already saw a sharp 1.25% slide—the largest decline since 2002. The most likely explanation for this is that, as might be expected, inflation has chipped away at consumers’ spending power. Based on available evidence, nominal incomes have not kept pace with average price gains.

India is on course for its very own version of stagflation: 5% growth with double-digit inflation. Given the major underlying price pressures, the central bank’s promise of “further action as warranted” must come sooner rather than later.

Read the original story at Israel’s Financial Expert