‘Reversal in Core Inflation Biggest Concern Now’

India's central bank has been under pressure over the past year or so, with trying to strike a fine balance between taming inflation and maintaining the growth momentum. Subir Gokarn, deputy governor of RBI in charge of monetary policy, discusses the dilemma the regulator faces as well as other challenges with Aniruddha Ghosh, Gayatri Nayak & Ruchira Roy, on the sidelines of an event organised by ICICI Securities

SUBIR GOKARN DEPUTY GOVERNOR, RBI

The central bank has just raised rates for the eighth time in quick succession. How difficult is the task of managing the growth-inflation trade-off now, especially with food inflation starting to come down?
Let us look at the supply-side factors first. Food inflation is coming down, but is still quite high. Oil prices have been firming up. But that process seems to have intensified given the global developments. What we are most concerned about is the fact that non-food manufacturing inflation, which is the segment of the index we have been using to reflect demand pressures, has seen a reversal which also implies that input costs are being passed through to the final goods or final products. Thus, the non-food manufacturing inflation that was 4.8% in January went back to 6.1% in February. It was a number we saw in the middle of 2010. It suggested the ability of producers to pass on pricing power was still strong, and from the inflation-management viewpoint that was not particularly a positive sign. So our interest rate actions were guided by these considerations and the likelihood the pass-through pressures were still persistent. 'Oil Spike to Hit Not Inflation Alone, but Global Growth Too' Gokarn expects India to grow at 8.6% but says recent reversal in inflation figures a big worry
With the crisis in West Asia showing no signs of abating, there are expectations crude prices could even cross $150 per barrel. What kind of an impact do you expect this to have on domestic inflation and subsequently on policy formulation?
We obviously are engaged in conversation with people who are tracking the global economy and the sense we get is as the price of oil crosses a particular threshold, it will not only have an inflation risk, but also a growth risk for the global economy. What that number will be is something the forecasters will start to converge on. From our viewpoint, we have to be aware of these risks. We have pointed out in our mid-quarter statement while growth drivers are relatively stable, we see risks emerging for 2011-12 and one of them certainly is the likelihood of this kind of oil price rise.
RBI also said in its recent policy review the nuclear crisis in Japan might force it as well as other nations to move to other conventional energy sources, thereby pressurising oil prices further. How will this complicate things?
That clearly is another factor which may push oil prices higher, both in terms of Japan's rebuilding on the basis of incremental shift to thermal energy rather than nuclear energy, and perhaps in other countries also where nuclear facilities will be subject to tests. So at least the short-term impact will be that the growth in demand for power would be met out of thermal capacity rather than nuclear. So that's another factor that will have an impact on the oil-price dynamics.
Is there a concern in RBI over private investment slowing down on account of the uncertainty over interest rate outlook and high commodity prices?
That has been a concern in our assessments right from the time we began our anti-inflationary policy trajectory. The concern was always to balance the forces that keep growth going and sustain growth in the future with the need to control inflation. So an aggressive action against inflation, by raising rates much higher than we did, clearly might have had the fallout. It could have slowed down growth and it could have within that, a stronger, more adverse impact on investment. So the balancing act we have tried to do, essentially looks at ensuring that the inflation objective is addressed without creating too much of an adverse impact on the incentives to invest. Of course, interest rates is just one factor that drags investment, there are other factors as well that may impact it. But at least in terms of what we could control, the objective was to make sure that we were not putting too much of a barrier in the way of investment through higher interest rates.
Are you concerned about growth being impacted?
I think we will end the year as per the advanced estimates with 8.6% growth. I suggest that the balancing act in terms of at least not disrupting growth has been reasonably successful. Inflation was as per our expectation, performing on track in the second half of 2010, particularly non-food manufacturing inflation, which peaked around April and then started to come down. But the recent reversal also has been a bit of concern. So in the sense the question to ask is had we not taken the actions that we did, where would the number have been. I think it is reasonable to say that the number would have been quite higher than what it is now. The fact that it has turned around suggests that these pressures still persist. That capacity utilisation is high, growth is gaining momentum and that means return of pricing power, i.e., producers can pass on input costs, and therefore, the need to be watchful on monetary stance is still there. Having said that, we can't be insensitive to the risks to growth, both global and domestic.
The recent Mohanty panel report on monetary policy formulation suggests RBI should use the repo rate as the single policy rate to signal its stance. is this what RBI is progressively moving to?
There is a huge amount of technical analysis that has gone into the report and it is important for market participants to understand the analytical foundations that have gone into the recommendations. The key issue there is that the corridor (of repo and reverse repo) that we have been operating so far is not a fixed corridor; it's a variable corridor because we had witnessed the corridor peaking at 300 bps and now it is 100 bps. The call rate, an indicator for short-term market liquidity, has been outside the corridor. Thus, the corridor has not functioned as a corridor for most of the time because the call rate has not moved between the boundaries. What the working group recommends is that we create an effective corridor by the repo being inside the corridor and not on the boundary. Above the repo we have something called an exceptional lending facility, where banks wanting liquidity but not having the capacity to borrow in the repo can get liquidity by accessing that expensive window which is set to be 50 bps above the repo. And below that is the lower part of the corridor, the reverse repo. If banks have surplus liquidity and if they want to park it with RBI, we will pay 100 bps less than the repo. The additional feature is that repo becomes the only rate that is announced. Others are fixed in terms of the intervals between the repo. It now brings the policy rate in the middle of the corridor and that was the key in terms of making the corridor most efficient.
Some banks have been seen making arbitrage in the call money markets and have been investing in liquid plus fund schemes. Has RBI taken any action on that front?
You have to look at our press release of March 21, 2007, which says that if banks borrow from the repo, there is really no view or constraint on onlending that.
Is the economy weakening amidst weak IIP numbers and high inflation?
One of the debates that have emerged in the last few months with the IIP showing signs of weakness is whether growth is slowing down. IIP is clearly showing signs of weakness; the question is whether that reflects a slowdown in the economy. We obviously look at a number of indicators other than the IIP — indirect tax collections, direct taxes, corporate sales and earnings and credit growth. So when you look at other indicators that tell you whether the economy is growing or not, they don't give you the same signal that the IIP does. I think the key message in the mid-quarter review was that there are risks that we should be watchful in 2011-12, and it has to do with both global developments and the persistence of inflation pressures domestically.
It will be almost nine months since the base rate system has been introduced. Has it improved the monetary policy transmission?
It's an ongoing assessment; our initial view is clear that monetary transmission has become visible. Banks are raising their base rates in the way that we expected that the framework should work. Their ability to add premiums to a constant base rate is limited unlike BPLR, where you could keep discounting it, and it was not very transparent; we did not see it till the data was reported. The base rate system is much more transparent and there clearly seems to be an impact on transmission.
Has monetary policy helped the common man who is still reeling under high inflation?
We have to recognise that the monetary policy has an impact on some drivers of inflation but not on others. So when we talk of bringing overall inflation down, there are other factors that need to be brought into play. Now when we talk of food inflation, something which the monetary policy does not directly impact, we have to look at other measures. I think some of the measures the Budget has announced, particularly in relation to proteins in general but specifically in terms of pulses, should have an impact in terms of higher productivity fairly quickly. I wouldn't be looking at a very long-term impact for this. So that's one very important way in which food prices can be brought under control. Monetary policy is basically maintaining the balance, it's not just inflation that impacts the common man but also growth.