Subbarao is not Volcker and India is not the US

While central bankers worldwide have continued to balance their policies to focus on reviving growth while keeping a lookout on inflationary expectations the policy environment in India has been totally opposite. I have argued for a long time with different logics that although the RBI started off its tightening policy at the right time and the right strategy it lost its way a long time back. The biggest issue that is of concern is the outsized view of the Central Bank on its ability to control inflation at a time of experimental monetary policy in most major economies. Today we are in a scenario where the manufacturing inflation has come down to around 3.5% and has been flat for the last eight months i.e. if the same level of manufacturing WPI continues till the month of July manufacturing inflation will statically fall to zero. The only two factors impacting inflation are food and fuel which are totally and completely out of the ambit of RBI’s monetary policy to control. Infact fuel inflation should also have been virtually zero at this stage given that global crude prices are at the same level on an average versus what they were at the same time last year and the INR has also been stable. Under the circumstances the reported inflation is due to the correction of previously controlled prices and is going towards reducing fiscal deficit pressures. As such this should be ideally removed from the reported inflation figures while RBI formulates its policy. Food price inflation in India is mainly due to two reasons, the first being the continuous and ill thought of increase in Minimum Support Prices by the current government and secondly the extremely inefficient infrastructure and transmission mechanism in the agri sector where the fall in wholesale prices do not get translated to the retail levels. There are a lot of food articles like edible oils, sugar, pulses, milk products etc where there has been a significant fall in global as well as wholesale domestic prices. However the translation to retail prices has been very weak. We are likely to see the wholesale food inflation come off very sharply over the next three months. However the impact on the CPI will need to be seen.

Domestic consumption has fallen drastically across sectors. Infact last month saw automobile sales fall in the mid 20% which has not been seen for a very long time in India. Slowdown has now started biting consumption in a big way and this was also reflected in the prolonged sales seasons across brands over the last 3-4 months. Companies across the board have lost pricing power.

Let us see a country like the UK. Here the growth in the current year is expected to be 0.6% and inflation projection is in the region of 2.8%. However policy rates are at 0.5% and money printing is on in a big way. Similarly Euro Zone inflation is expected to be around 2% & the ECB overnight rate is at 0.75%. Growth in the Euro zone is expected to be virtually flat this year. Similarly in the US overnight rate is between 0-0.25%, inflation between 1.5-2% & growth at around 2.5%. The US FED continued to print significant amount of money every month. Over the last three years despite extremely anaemic global growth commodity prices continued to be high mainly due to the flow of cheap money into commodity ETF’s and the huge growth in commodity hedge funds. Incrementally this impact has started wearing off now where the anticipation of the end of the money printing cycle in the USA is making investors wary of commodity funds. Under the circumstances despite an improving global outlook for growth commodity prices are actually correcting. This shows the huge speculative element is most global commodities. Most major commodities like Crude Oil, Copper, Iron ore etc etc have corrected by nearly 10-15% over the last two to three months. Like I wrote in my last article the inventories of a large number of commodities continue to be high globally.

The most absurd thing that I read about is when some learned people start comparing the RBI Governor to Paul Volcker and start mentioning that RBI should keep interest rates high like Volcker did in the US in order to weed out inflation. The reality is that India is not the US. At the time when Volcker started his tightening in the US the US economy was nearly 30% of the global economy. China had not emerged at that stage and the US formed 25-50% of the consumption of most major industrial commodities. As such when such an economy starts controlling demand and restricting growth the impact is felt in that country as well as worldwide. This is similar to the opposite what has happened as the US Fed started printing money in a big way where the amount of money that it generated has created outsized prices for a large number of commodities. The slowdown in the US at that stage led to lower demand for commodities while supplies continued to grow. This created a slack in the global economy which kept commodity prices down for a prolonged period of time and was used to its advantage by China in the 1990’s where low commodity prices helped them grow aggressively with low inflation in that decade. China is what the US was to the commodity markets 20 years back (except for crude oil & some food commodities). Now if the Indian Central Bank looks ahead which it ideally should it will see that the trend rate of growth for China is likely to come down from 9% to 7%. The hugely commodity intensive nature of growth that China has had in the past is likely to moderate going forward as the focus of growth shifts to boosting the quality of lifestyle and consumption. China today constitutes 40-50% of the consumption of a large number of industrial commodities like Copper, Steel, Aluminium and many others. As China moves to a lower trend growth and as inflationary pressures also build up in the Chinese economy due to rapidly increasing wages and salaries they will need to live with a lower growth. For too long China kept its wages low and that too artificially. Now the aspiration of people in China are growing and the rapid up move of incomes in order to match its infrastructure and global standing will make inflation a bigger concern over the next few years. A decline in the working population as a result of the one child policy will also start soon. This will put further pressure on costs in the country. As such lower Chinese growth combined with increasing supplies of various global commodities will be the biggest contributor to lower global inflation over the next few years.

The outsized view of the ability of RBI to rein in inflation has been mentioned by me repeatedly. Over the last one year the RBI has cut policy rates from 8.5% to 7.5%. However by not letting system liquidity ease by taking stronger steps, it has been a reluctant rate cutter. It has show to the galleries that it has cut rates, however if liquidity remains tight interest rates cannot come down. India comprises just around 2% of the global economy and unlike 20 years back most economies are very open today, entry barriers are low, markets are integrated & custom duties are very low. As such in a more closed economy with lot of barrier, which India was 2 decades back the impact of RBI policies on inflation was much greater. Where RBI policies are effective are more on restricting growth rather than controlling inflation. As such if the aim of policy is to reduce demand to such low levels that companies lose total pricing power and start selling at low margins or at losses then one can say that the policy has been very very effective. If the policy is forward looking as has been with the BOE where they have maintained that inflation will be high in the near term but moderate over the long term then we could have a more effective monetary policy in India. The ostensible reason given to keep interest rates high is to reduce the second round impact of high food and fuel inflation. This is not a very plausible theory under the current circumstances. Food inflation is more a structural issue and improving quality of living of people will continue to move people to consume more of protein rich food, milk, vegetables etc and as such if productivity and supply chains are not improved it is unlikely that food inflation will come down. This is more of a governance issue. As such trying to build second round impact of food inflation into monetary policy is ridiculous.

Instead of appreciating the move of petro prices towards market rates it was actually strange to see RBI mentioning in the latest policy that the scope to reduce rates is less due to the correction of regulated prices. This is what everyone wanted, right?

Overall I would say that it is important to formulate monetary policies looking at all externalities as well looking at the impact of non traditional policies being followed worldwide. Even if some moderation in inflation is achieved by killing growth totally and destroying corporate balance sheets it is not really worth it. RBI IS NOT THE US FED & INDIA IS NOT THE US.

After starting a decent up move subsequent to the presentation of the Union Budget we have seen the markets hit by the hawkish RBI policy, the Cyprus issue as well as the DMK pullout. I personally would not give too much importance to what the RBI has said as they have continuously and constantly gone wrong in their inflation projection. Over the next three months the headline inflation is likely to plummet despite the periodic increase in diesel prices. The reasons for this will be three fold; last year in the months Feb-April there was a rally in global commodities, this year there has been a correction, secondly the impact of INR depreciation as well has higher commodity prices was still being passed on by manufacturers, thirdly we had a 2% increase in excise duties which got passed on in the months of March & April. These three factors will see inflation decline to around 5.5% or lower over the next three months and RBI will be forced to cut rates.

The Cyprus issue in any case should not have any long term impact and is not even worth talking of. It is just an even to create a bull market correction. My view at was that we will see a high in the US and German markets first and then other major markets will follow. There is no reason to believe that this will not happen going forward.

The bigger issue as far as India goes is the political situation. Over the last two years we had a stable government that did not work. Now that it had started to work it is no longer stable. How this will play out will be important for the markets. Will the government get into a cocoon again or will they move towards reviving the economy as a last ditch attempt to regain some credibility in the mind of the electorate? Till date the statements at least show strong intent, however the action will be much more important.