RBI may fall behind the curve in fighting inflation

India Wrap
Economic overview


ML economist Indranil Sen Gupta is of the view that RBI, for all hawkish talk, risks falling behind the curve in fighting inflation. Indranil is continuously emphasizing the rising inflationary risks of runaway monetary expansion during multiple supply shocks.

Surplus money typically takes 18-24 months to spill over into inflation: we are already a year into potential disaster. It is for this reason the RBI is repeatedly hiking CRR.

20% M3: Key inflation risk during supply shocks

ML economics team is concerned about rising M3. End-April 08 M3, at 21.2%, by far exceeds the own RBI’s 16.5-17% projection (and even MLe more relaxed 18%). The money gap, i.e., the difference between actual and ‘optimal’ M3 growth, has been climbing up fast and furious in the past one year.

Why is the Ghost of 1997 smiling?
To Indranil, things look eerily like the mid-90s at times. 20%+ M3 growth had then accommodated a poor harvest into double-digit inflation. The then RBI governor –now chairman of the Economic Advisory Council - did finally win the war against inflation, but Volcker-like, at the cost of a 5-year recession.

To cap it all, bouts of rupee volatility – like now - forced the pace of monetary
tightening. The RBI was not able to pull the monetary measures back fast enough before they impacted growth. Once the realization of disaster set in, the then RBI Governor desperately cut CRR 400bp during April 96 - January 97.

Growth nevertheless plummeted to 4.3% in FY98 from 8% in FY97, the industrial slowdown aggravated by a bad harvest.

All is not lost yet; present inflation spike a supply shock

Indranil however is of the view that there is still some time left for RBI to act. If the RBI is able to rein in M3, Governor Reddy could still snatch victory from the jaws of defeat. He thus expects another 50bp CRR hike by July, in addition to 75 bps announced in April. A higher oil import bill and lower FII flows paradoxically may also help by reducing capital inflows!

The present inflationary spike is still supply-led, in our view. The profile of
inflation, Indranil points out, points to a concentrated supply shock rather than a generalized demand shock. Of the 440-commodity wholesale price index basket, about 170 are inflating 5%+ (214 March 07) and 70 20%+.

A good South-west monsoon, predicted by the Indian Meteorological Department, could actually pull down inflation by July, especially if the government is able to cut steel prices (Chart 4).

There are two upside risks to the MLe inflation forecast. First, anecdotal evidence suggests rice price inflation on the ground is higher than the 7.5% recorded in the official WPI. Second, electricity prices are expectedly beginning to reflect the increase in tariffs following last year’s 10% coal price hike.