RBI is not behind the curve, the curve just got steeper

There has been lot of debate over the last few weeks on the monetary policy stance of the RBI. As I listen to lot of commentaries and the opinions of economists and media experts the thing that I hear the most is that the RBI is behind the curve and it should have tightened more aggressively. However I find myself totally disagreeing with this view as RBI has been the most aggressive central bank and has tightened both policy rates as well as the CRR quite aggressively. In fact the Indian banking system has been in severe liquidity shortage for over 4 months now .

First of all the inflation as measured in India is largely commodity inflation and RBI has very little control over that. Indian consumption of most commodities except for some agro commodities is just 3-5 % of global demand. As such in a scenario where most large Western economies have ultra loose monetary policies and China (the biggest contributor of EM inflation) has not tightened enough there is very little RBI policies can do to control this inflation. RBI by increasing its policy rates can take the interest rate curve up which can reduce final consumption of manufactured products; however it cannot control the input cost inflation. As such aggressive tightening will only reduce consumption and investment demand without reducing the inflation as is measured in India. This will cut into the margins of manufacturers of products and make Indian manufacturing more uncompetitive. RBI policies have more influence on asset prices where both land and real estate bubbles have been controlled well by the RBI.

Lot of economist are writing columns proposing RBI to go the Paul Volcker way and hit down on inflation with a sledgehammer. I do not believe that it will have the same impact as the US at that time and even today is the largest economy in the world and it can influence its own inflation and growth by its policies. In an open world economy India does not have the same abilities. Primary article inflation driven by food and other mineral and input prices is driven by global factors and this time around freak weather patterns globally have hit both food production as well as flooding in countries like Australia have boosted prices of coal which has had follow through impact in terms of increase in steel, power prices etc. These are events that cannot be predicted or modeled and the situation might be totally reverse next year around. Increase in Onion, vegetables etc. prices cannot really be modeled. The key point also is that even if we believe that food price inflation is demand induced, how monetary policy can influence food consumption is totally beyond my understanding.

The IIP data for November has already shown the first signs of slowdown of growth and the extremely tight liquidity has already started hurting credit flow for investments. Manufacturing inflation as per the latest data was just around 4.5% which reflects that the pass through of primary inflation is not happening in the same ratio to the consumers and that is the impact of the tight monetary policy of the past. Even if we measure it in terms of sequential growth manufacturing inflation is lagging behind primary inflation quite significantly.

The ECB has already started talking of an inflation threat and the Chinese have finally woken upto it. As such if China lets its currency appreciate and becomes a bit aggressive on its monetary policy then it will do the work for us also. Central banks like that of Korea also surprised last week with a policy rate hike. I think that it is time for the Indian policy makers to just follow the written path of small rate hikes. There is also the need to improve liquidity in the system and I believe an SLR cut is called for as it will improve bank margins at the margin and will also improve liquidity in the system. They cannot obviously cut CRR as it will run contrary to their stance of an aggressive policy.

Equities

The call that equity investors have to take is the scenario that they see a year from now and not next week or the week after that. I believe that 12 months hence when we sit and analyze the markets headline inflation could be 4-5%, the government would be more stable as the scams and governance issues will be behind us, growth outlook would be looking much better and the situation will be sanguine for investments. At that time in all probability the markets will be 25-30% higher than current levels and one will not be able to see reasons why markets should not be doing well. Investors should just focus on indentifying the right stocks and invest in them rather than being focused on the immediate few days or weeks. At this stage when most analysts are giving bearish and dire views the only thing that I will like to repeat is that –

“Its important to grab entry points in bull markets as,
They come with gaps and are normally short lived”

Unless off course you believe that we are in a bear market.