Reflecting on the official Q3 FY23 data, the minutes of the monetary policy committee’s (MPC) February 2023 meeting have come as a revelation. Analysing the specific assessments of Ashima Goyal and Jayanth R Varma, it becomes increasingly clear that there is a difference of opinion within the MPC. Apparently, the RBI, on its part, is paranoid about inflation control and is leaving no stone unturned to impose its narrative on the rest of the committee. Evidently, all external members are at best reluctant when it comes to further monetary tightening.
The apparent ‘higher for longer’ narrative, borrowed from the US Fed, is evident from Michael Patra’s assessment as he notes that “in the final analysis, the size and timing of rate changes is the best embodiment of the stance. While keeping in mind the objective of growth, the foot must remain on the brake as we chart our future trajectory.”
Challenging the RBI’s ‘imported’ conventional wisdom, other committee members note that industrial activity, especially manufacturing, is still in a nascent state of recovery. The phenomenon is now confirmed by Q3 FY23 numbers. When the authors delved deeper into the concerns, Macrobond data revealed that based on Q2 FY23 results, EBITDA (earnings before interest, taxes, depreciation and amortisation) for Indian manufacturing enterprises has fallen, first time in two years.
Making The Consumer Pay
At the same time, EBITDA to sales ratio is now the lowest in three years for all enterprises in India. Unsurprisingly, this corresponds to a period when the countercyclical monetary stance was adopted and is happening when commodity volatility is significantly contained. There is a possibility that a combination of rate transmission and moderating consumer demand is at play here, assuming perfect competition exists.
The authors hypothesise that this is potentially lethal for economic stability in the current environment of rising interest rates. This is because non-rationalisation of the GST rates on essential items may subject households to liability of incidence of tax (under the tax shifting theory in perfect competition), as enterprises eventually offload the entire incremental input burden onto the consumers. The understanding is that, fundamentally, enterprises must earn normal profits in the long term, spawning inflationary pressures for households. The inclusion of the El Nino effect can potentially lead to a worse conclusion still.
Goyal further cautions, “a sharp rise in the real policy rate, substantially above unity, triggers a shift to a lower trend of private investment and growth, then the sacrifice ratio of disinflation can be very high, as it was in the 2010s…over-tightening today does not necessarily improve the future. Inflation can rise over time because supply bottlenecks worsen.”
Based on the research of the authors, there is a positive correlation between capacity utilisation (with a lag of three) and wholesale prices (represented by the WPI). What this means is that any change in utilisation levels in the Indian economy have a direct bearing on wholesale prices, three quarters later. Data suggests that capacity utilisation levels peaked at 74 percent first in Q4 FY22-Q2 FY23. The question is that if today’s declining WPI is connected to what happened three quarters earlier, tomorrow’s WPI number may be higher since utilisation levels will be forced to fall.
Forced Recession To Cool Prices
Taking a leaf out of Goyal’s hunch, the authors believe that forced recession can at most subdue inflationary tendencies in the short term, stoking the inflationary demons to reappear later. The fact of the matter is that the RBI is forcing the Indian economy to return to a recessionary phase when the business cycle is yet to run its course.
At the same time, the RBI’s monetary wizards are taking the economy to a state, where the policy rate is higher than the GDP growth rate itself. What this means is that based on estimated numbers, the policy rate now exceeds the subsequent quarterly real GDP growth numbers by over 100 bps. When this happens, the debt repayment capacity of both government and private borrowers will be significantly impaired and economic hardships are encountered, that are lingering in nature.
The last time this situation was encountered was between Q4 FY19 and Q4 FY21 and the differential was around 570 bps, primarily on the back of massive economic contractions in FY21. Interestingly, the previous GDP growth-policy rate anomaly occurred after completing the entire business cycle of 13 quarters. The trouble is that the anomaly underway at this time has occurred just after 6 quarters! Given the timing, we suspect that the monetary authorities have not given the economy enough time to recover lost capacities and impaired supply chains.
More Pain Ahead
Our view is that the current tightening, with utter impunity towards economic green-shoots, will be very painful for the economy at large in the short run. Firstly, as enterprises will be forced to undergo cost rationalisations, more job losses will be encountered. Secondly, the high interest rates at a time when public debt to GDP ratio is at an all-time high will reduce fiscal flexibility, despite an impending election year.
Thirdly, the ongoing deglobalisation will force economies to work in increased isolation and domestic sourcing may increase input costs. Since fresh capacity creation will be disincentivised in the current climate, the fight against inflation may not conclude with the ongoing tightening.
Therefore, it is important for RBI to realise that it is dealing with a guilt complex regarding inflation and that it needs to be patient, unless it risks overdoing things, holding economic recovery to ransom. Perhaps, Varma has a point when he suggests, “In the second half of 2021-22, monetary policy was complacent about inflation, and we are paying the price for that in terms of unacceptably high inflation in 2022-23…I fervently hope that we do not pay the price for this in terms of unacceptably low growth in 2023-24.”
Karan Mehrishi is an economist, specialising in monetary economics and fixed income. Birabrata Panda is an economist focusing on data analytics. Views are personal and do not represent the stand of this publication.
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