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Binary equation

Can stability be achieved by sacrificing growth?
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Renu Kohli   |   Published 14.06.22, 02:35 AM

Has the macroeconomic configuration turned binary? With inflation occupying centre stage, the choice seems fast splitting between stability and growth. Can the former be secured without compromising the latter? That’s the worry with policies swinging to address price, exchange rate and external stability. This is not to say that growth has receded to secondary position. But as interest rates harden and fiscal policy diverts to counter inflation, safeguarding stability without cost to output is fiendishly difficult. In any case, a tipping point appeared to have been reached with inflation hurting growth. There isn’t much to choose between a rock and a hard place. This is where the Indian macro constellation is now.

In the past one month, a series of monetary and fiscal actions, including interest rate increases and reductions in fuel levies, tariffs and duties, has raised the spectre of a retarding economic recovery. Inflation, which has been above target for more than one year and climbing since last September, surged close to 8% in April. Food prices rose faster, energy and transport prices paced in double-digits, while price growth of most other goods and services ranged between 7-9%. The alarming spread can become a self-reinforcing spiral as food and fuel prices shape households’ inflation expectations, which drive consumption and pricing decisions. This elicited a surprise, inter-meeting rate hike and liquidity withdrawal on May 4 by the Reserve Bank of India. Another rate increase followed last week.


With inflation expected in the 7.5% region until September — an average of 6.7% this year — interest rates have further to go. The real rate — nominal interest rate minus the rate of inflation — remains deeply negative. It implies negative returns to savers, for instance, on bank deposits. By contrast, borrowers, including the biggest ones or the government, benefit. The degree of interest rate adjustments required may be substantial therefore.

Inflation isn’t the only problem. Incessant depreciation pressure upon the rupee is another hurdle. The steady drain of foreign capital totalled $30 billion in eight months to May. Tightening overseas conditions, a strengthening dollar, and rising commodity prices are other weakening factors that are enduring. Rising imports, including costlier crude oil, have also enlarged the current account deficit, triggering concern about financing difficulties. This triumvirate is a red alert for macro instability. What makes it a troublesome quad is an indebted, precarious public financial position that is now additionally burdened by anti-inflation measures costing loss of fuel revenues and higher subsidy expenditures.

Higher interest rates are required to check inflation, retain foreign capital that’s getting attracted to better returns elsewhere, and to ensure the current account deficit is kept at sustainable levels. Dampening demand is the chief route through which monetary policy works. With the interest rate actions taken so far, existing and new bank loans for business, housing, personal and other purposes have already become more expensive; mortgage payments and debt servicing costs could increase further. Corporate profits, which grew handsomely on the back of extraordinary monetary easing in the last two years and tax cuts in mid2019, will also slow down. Bond yields, which reflect the government’s cost of borrowing from the market, have risen significantly in this quarter and are likely to go up, adversely affecting government finances. In summary, these adjustments could hurt growth.

The alternative was no better; possibly worse. Signs that the relentless price rise was dulling demand were becoming apparent. The recently released GDP data show a strong comeback of 8.7% in 2021-22, after contracting to -6.6% last year. From a current perspective, however, the last — January-March — quarter’s performance sheds better light: a progressive economic deterioration is observable with private consumer expenditure declining nearly -3% upon the December quarter; in annual terms, aggregate private consumer spending rose just 1.8% in the period when the pandemic had waned. Most services restarted operations and demand was expected back revengefully.

This isn’t the only testimony. Retail price hikes forced by input cost pressures are hurting rural demand, nonfood and discretionary spending much more than urban and essential consumption, according to fast-moving consumer goods companies’ reports. This typically happens when living costs rise and real disposable incomes get squeezed. The smaller firms also exited at the fastest pace last quarter because of their inability to pass on higher input costs to consumers, as per the market research agency, Nielsen; this accentuates a slowdown because small businesses help subdue prices and maintain spending of vulnerable consumers.

The external macro environment is turning more adverse. Potential stagflation scenarios are gaining ground in the advanced countries. Last week, both the Organisation for Economic Co-operation and Development and the World Bank cut growth expectations steeply for this year and the next with higher inflation. In the United States of America, inflation shows no signs of peaking so far, its future path is extremely uncertain, the US Federal Reserve has only just commenced tightening, and the significant interest rate hikes required ahead have raised the odds of a recession. A slowing world economy would also slow down trade growth. Indian export growth, which has been strong till now, would be impacted as would the trade deficit. This is another prospective threat to the external accounts.

Both the government and the central bank have endeavoured to talk down inflation and interest rate expectations, allaying fears that growth would be harmed. Reiterating the commitment to contain inflation, the RBI governor underlined that growth needs would be kept in mind as a successful operation (inflation control) cannot leave the patient dead (the economy slips back). At last week’s review, the RBI retained its 7.2% GDP growth prediction for this year even as it raised the forecast inflation by one percentage point. Many believe inflation may be higher than official expectations because of higher oil prices and a catch-up by services, which were inaccessible for over two years. Owing to the impact of high inflation, several institutions have lowered their growth expectations, including the World Bank.

To maintain a favourable macro environment and lead it to maturity with a rise in real incomes is the challenge. The next few quarters will bear out how economic growth withstands and responds to the difficult adjustments.

(Renu Kohli is a macroeconomist)

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