Misreading the dead cat bounce

By Rajiv Kumar

RBI's POLICY announcement on 29th October carried no surprises. Repo rates were raised by 0.25 basis points and rates at which commercial banks can borrow under the marginal standing facility were lowered by the same amount. Normalcy was brought back in the money markets with the LAF corridor brought back to within 100 basis points. The yield curve regains its ' normal shape' and all this was applauded by the equity markets, with the Sensex closing 355 points above the previous day. I notice, however, that several commentators and edits have risked being chided as spoil sports by pointing out that markets are perhaps being irrationally exuberant. Inflation The governor has demonstrated most unambiguously that his exclusive objective for now is to tame inflation. He wants to dampen inflationary expectations that showed a marked rise during the July- September period before they become more deeply entrenched. Therefore, he has shifted his attention to retail   inflation ( CPI), which has remained around 8 per cent for the past 60 months, with core retail inflation at 7- 8 per cent and food inflation above 10 per cent. By overtly focusing on CPI as the basis for policy stance, he is following a well worn RBI practice of using a mix of retail inflation measures, but which has not generally been openly admitted. But will interest rate hikes, cheered along as always by the Chairman of the Prime Minister's Economic Advisory Council, Dr. Rangarajan, by themselves suffice to reverse inflationary expectations after 60 months and will the economy not suffer inordinately during the ensuing period? The analogy with chemotherapy, to which my family has been unfortunately recently exposed, is an apt one. The oncologist is sure that if a strong enough dose is administered long enough, the malignancy will be rooted out from the system. But often he/ she stops short or staggers the dosage because sustained chemotherapy not only kills both malignant and benign cells, but also risks destroying the bone marrow, thereby rendering the system completely incapable of positive response. With credit growth slowing down to 11- 12 per cent; consumption and investment demand both lower than in comparable periods in the previous year; and political uncertainty bringing private investment to a standstill and looming ominously on the investment sentiments, one wonders if the economic system's bone marrow is not already displaying signs of being near comgacy atose? Perhaps the governor, like some doctors, prefers taking the risk of pushing the patient in to the exclusion ICU, used for patients with immunity levels, before acting. The danger always is that even if yanked back from the precipice, the patient, in this case the economy, becomes crippled for a long time. The governor seems to believe that downside risks for growth, reflected in his optimistic growth forecast of 5 per cent, are still manageable but the upside risks of rising inflationary expectations are getting out of hand. I beg to differ. Because rate hikes will do precious little to curb inflation that is fuelled by shortages of non- cereal food supplies and burgeoning fiscal deficit. Profligacy The government is now fully in election mode; 75 per cent of the fiscal deficit target has already been exhausted in the first eight months; and tax revenues are significantly lower than planned, there is virtually no hope whatsoever for reducing the government borrowing requirement except through imaginative accounting, which will not help in any case. But defenders of inflation- targeting argue that the RBI can do precious little as structural constraints on growth, supply shortages and fiscal profli- comgacy are out of its hands. It has only a single policy variable to play with. Well that is assuming that Mint Road and North Block cannot be in sync and we cannot expect a coherent a government policy that uses all feasible tools to prevent the system from going into the ICU, from which it takes a long time to recover because of   investment famine, plummeting growth and massive job losses. Compulsions The hope was that Raghuram Rajan would bring to policy making this hitherto missing dimension of overall macro- policy coherence. This would have implied that in between the two RBI policy announcements, the government would have taken real steps to address those structural constraints by simplifying environment clearance and not passing the LARR, rein in fiscal deficit by removing the diesel subsidy and not passing the FSB; or taking steps to reduce the criminal waste of 40 per cent of agriculture produce or eliminate brazen and open cartelisation in the wholesale fruits and vegetables markets by abolishing the APMC act in UPA- ruled states . But none of that has happened. So what is new that the governor brings to the table of policy making, apart from his global reputation? We are back on the macroeconomic roller coaster propelled upwards on the inflationary spiral by a loose fiscal regime and lack of policy response to supply side bottlenecks and hurtling down by ever tightening monetary policy. This scenario is to the utter delight of the hide bound monetarists. But a governor more sensitive to the social pains of job losses and large scale shutting down of small and medium enterprises, that are unable to withstand the double whammy of interest hikes and higher input costs, would have acted differently. He would have used his convincing powers, coalition building skills and intervention in the public domain to bring about the much needed policy coherence and forcing North Block to come up with real action in place of rhetoric. Instead there seems to be the usual capitulation to political compulsions. The governor seems happy enough receiving accolades from equity brokers, FIIs and foreign bankers. But surely he realises that the markets are making the proverbial ' dead cat jump' because there is precious little to sustain this euphoria. Come the next quarter's GDP growth numbers or even a hint of tapering by the US Fed around the new year and markets will be in deep funk   again. By being the inflation hawk, Raghu is playing to a well known script, which does not include sustained growth with low inflation, critically needed today. We were all expecting something different. The writer is Senior Fellow, Centre for Policy Research, New Delhi.