Lost in the woods

There is a famous song by Tamil poet Bharathiyar starting "Thikku theriadha kaatil...", meaning "not knowing the directions in the forest" (implying "lost in the woods"). Well that probably sums up the current status of our policy makers, both in Mint Street and North Bloc. One would ideally like to be sympethetic to their plight if not for the fact that their woes have been self-inflicted to a large extent.

First, lets rewind back to June /July this year, when monetary policy actions became increasing aggressive with intent to tame inflation. With every successive rate hike, the RBI stated that fighting inflation is of paramount important and its imperative to sacrifice short term growth to achieve this. The stated outcome of the RBI policy actions was to reduce aggregate demand in the economy (in other words, slowdown the economy). The finance ministry officals (including the FM) endorsed this - lots of interviews /sound bites are available on the net - sample one below
http://www.dnaindia.com/money/report_moderating-aggregate-demand-is-critical-to-check-inflation-pranab-mukherjee_1556075

Now that the growth has started coming off, shouldn't the policy makers be celebrating? After all, wasn't this the expected & desired outcome they hoped for to tame inflation? Alas, they didn't truly believe it would happen!

Its not too difficult to see why there are no high-fives....
1. Inspite of this fall in growth, there is no firm handle yet on inflation. WPI is still well above 9% and all the predictions for it to come down to 7% by March are based on base effects which will start to show up from Jan onwards and not due to a firm view that prices will cool off significantly. The truthi is much of headline WPI dynamics are based on food prices, global oil & other commodity prices and electricity prices - all of which are not directly influenced by the RBI interest rate actions. So, though growth has slowed down as expected, there is no guarantee inflation will fall dramatically as a direct effect. The question then is why was the RBI so aggressive with its monetary policy actions to bring down demand if much of headline inflation are not directly correlated? In their defence, they were fighting potential generalisation of inflation through wage spiralling and also importantly overcompensating for an expansionary fiscal policies of the Central Government. Still, one cannot but wonder if a wrong medicine of wrong dosage has been used to fight the inflation ailment.

2. The other reason why there are no high-fives is because the way global growth outlook is looking, the current moderation in India cannot be seen as being temporary. If exports were to come off sharply, then the growth moderation can be pretty sharp as well and that would be difficult to arrest. It is here that the recent policy actions have been more difficult to understand. The global issues have not cropped up suddenly overnight. They have been brewing for the last 6 months and thats been obvious to probably all earthlings. Many emerging market central banks across the globe have actually taken easing steps in the last 3 months (Australia, Brazil, Turkey, Israel, Indonesia, Thailand have all cut rates recently, to name a few) to facilitate domestic growth amidst the global downturn. Yet, the RBI continued with its hiking policy as late as end October with specific intent to reduce growth, inspite of knowing the lagged effects of their policy. In other words, when a central bank hikes rates in end October, its intent is to slow growth atleast through the next 2 quarters (ie Q1 2012). In the face of the global headwinds, the Indian monetary policy has been focussed on pulling down growth atleast till beginning of Q2 next year!

Now its probably more clear as to why there are no celebrations nor claim of credit. See how the fall in growth is being quickly explained as due to global factors - "hey, weren't u guys tom-toming about need to bring down short term growth to achieve long term price stability? congrats folks - what u don't want to accept them?" If growth slowdown is due to "global reasons" and sticky inflation is due to food & oil prices, one wonders what the successive aggressive monetary tightening measures from June to October were for?

The recent Indian policy actions have been very unique & isolated compared to the rest of the world and was portrayed as essential given India's unique domestic driven economy and to reduce domestic demand pressures. Yet, there is a sudden fear that the precarious global scenario will cause an even sharper fall in domestic growth, especially given that full impact of the monetary policy actions have not yet played out. The real question is why this could not have been foreseen atleast 3 months back, when the global issues were apparent to all & sundry. Thats a question only the policy makers can answer and have to answer.

The only silver lining in all this is there is more scope for monetary actions on the reverse side as well - the more you hike, the more you can cut to foster growth. One can hope that such a course correction will happen sooner than latter.