Opinion An audacity deficit

Not really. Here are some facts about India’s inflation. Inflation wasn’t triggered in mid-2010 by a bad monsoon,as those with selective amnesia would like us to believe. Rather,wholesale inflation was already in the double digits by mid-2008,and it was not because of high food or oil prices. Non-food manufacturing (core) inflation had risen to over 8 per cent by September that year,as had consumer prices. Inflation collapsed in 2009,but entirely because of a massive decline in global commodity prices. At the first hint of a domestic recovery,core inflation jumped nearly 5 percentage points in six months by March 2010.

Here are some more facts. In 30 of the 48 months prior to the Lehman crisis,the banking system was in excess liquidity averaging about 1 per cent of bank deposits. Over those 48 months,bank credit grew at an average rate of 30 per cent against a nominal GDP growth of 14 per cent. Add to that the 4.25 percentage points cut in policy rates,4 percentage points of reduction in the cash reserve requirement and 5.5 percentage points of GDP in fiscal stimulus (Central and state government) following the Lehman crisis,and one can just imagine the credit,liquidity and demand overhang looming over the economy at the start of 2010.

This is not to say that the stimulus in 2008-09 was wrong. That was the right thing to do. The problem was that the stimulus was withdrawn too slowly and too late. In FY10 and FY11,India grew at astonishing rates of 8.6 per cent and 9.3 per cent,respectively. But during those years not much of the stimulus was taken out. Monetary policy was truly tightened only in 2011,when growth had already slipped to 6.2 per cent and fiscal policy in late 2012,when growth had slowed further to 5 per cent.

Ask any central banker what happens if an economy is left unattended with that amount of excess demand for that long. The answer is always inflation.Whether it takes the form of skyrocketing prices or also creates asset bubbles and currency overvaluation depends on country-specific policies,regulations and market structure. But inevitably,the economy adjusts through sharp declines in GDP and credit growth,exchange rate depreciation and bad loans,that is,what economists call a “hard landing”. Sounds familiar? That’s what has happened in the last two years.

How does one “soft land” an over-stimulated economy? By tightening early and aggressively to curb demand quickly. To be fair,things were made difficult as the government kept fiscal policy excessively loose till lately. But until mid-2011 (read the quarterly policy statements),the RBI too believed that inflation was driven by supply constraints. Consequently,it only tightened in hesitant “baby” steps and remained woefully behind the curve. In the pre-Lehman period,policy rates were tightened as late as in August 2008,five months after inflation had peaked. In the post-Lehman episode,rates were tightened until November 2011,although the sequential pace of inflation had already been falling for eight months. Some will argue that in hindsight we all have 20/20 vision. Not really. By mid-2010,several commentators were warning how the RBI was getting the inflation drivers wrong and needed to act more audaciously.

What’s the consequence of remaining behind the curve for this long? Inflationary expectations come unhinged. It is true that the RBI has consistently warned of the dangers of letting expectations get unanchored. But simply repeating that it wants to bring down inflation to the 4-5 per cent range doesn’t anchor expectations. Actions do. The RBI’s insistence on taking only “baby” steps missed the urgency that the 22 months of near double-digit inflation over 2010-11 needed. As the RBI’s own surveys reveal,inflationary expectations that were anchored around 6 per cent before the inflation scare of mid-2008 jumped to 12 per cent by late 2009 and have remained there ever since. Once expectations get unanchored,reducing inflation requires much greater demand destruction.

So the problem wasn’t that the RBI tightened too much; the problem was that it tightened too late. And the same goes for the government. It wasn’t till the new economic management team took office in mid-2012 that the government acknowledged that not withdrawing the fiscal stimulus of 2008-09 for three years had kept demand excessively high and exacerbated inflationary pressures. To be sure,it has followed up with the largest withdrawal of fiscal stimulus in more than a decade. Unfortunately,this happened only in the last six months,when most other engines of growth had slowed to a near standstill,not when growth was averaging 9 per cent.

So the supply constraints didn’t matter? Absolutely not. They combined with the global slowdown and the policy and regulatory uncertainty in 2011-12 in reducing corporate investment sharply,which ended up lowering India’s potential (or capacity) growth to around 6 per cent today from 8-8.5 per cent back in 2003-08. Any turnaround in potential growth requires investment to revive and these constraints to be eased substantially. That said,inflation flared up because policy allowed demand to run ahead of capacity for too long; the supply constraints just worsened it. There is no Indian exceptionalism and we do not defy the laws of economics.

Where do we go from here? With wholesale inflation falling and the fiscal policy being tightened,the clamour for monetary easing has intensified. But the RBI knows full well that with inflationary expectations still alarmingly high and little slack in the economy,even a modest upturn in demand could reignite inflationary pressures. To extricate itself from this bind,the RBI needs to clarify what it believes to be the current drivers of inflation and growth,such that policy actions are seen as consistent with those views. So far,it hasn’t. Instead,it has kept cutting rates while lamenting that the space for easing is limited; a strategy that could easily unhinge inflationary expectations further.

The writer is senior Asia economist,JP Morgan Chase. Views are personal,express@expressindia.com