RBI economists fear prices singeing growth

MUMBAI: Economists at the Reserve Bank of India have for the first time raised the spectre of stagflation, a period in which economic growth slows and prices rise, shaving off the benefits from the past decade’s prosperity.

The economy is poised to grow slower this fiscal than the last and inflation may be higher than the previous year, says a document released by the Reserve Bank of India’s research team ahead of the annual monetary policy review. “Policy interventions are necessary” to control inflation even though risks to growth remain, it says.

“Episodes of high inflation have typically been followed by slowdown in growth rates,” says the Macroeconomic and Monetary Developments report, discarding the Phillips Curve theory which says there’s a trade-off between inflation and growth. “Recent evidence suggests that while it may hold for very low levels of inflation,” it is not relevant for all times. “At high levels of inflation, growth could be lower, coupled with higher unemployment ,” it says.

Inflation is stubbornly high at 9%, despite eight ‘baby step’ policy rate increases by Governor Duvvuri Subbarao. With prices pinching the common man and even corporate earnings, economists from Citigroup and Goldman Sachs to the International Monetary Fund have cut growth estimates. At the same time, all of them have raised inflation forecast as demand remains strong and global commodity prices zoom due to easy monetary policy by the US. High prices are holding up capacity creation.

An ET poll shows that Subbarao may raise the repo rate, the rate at which RBI lends to banks, 25 basis points to 7%. Reverse repo rate, the interest that RBI pays banks for parking excess funds, may go up by 25 basis points to 6%. A basis point is 0.01 percentage point.

“Stagflation is a distant concern,” says Dharmakirti Joshi, principal economist at rating agency Crisil. “It is too early to talk about it, especially since the Reserve Bank is talking about maintaining a trend growth. It probably wants to drive home the point that inflation needs to be tamed to maintain the growth momentum over the medium term.”

Professional forecasters have revised their growth forecast for FY12 downward from 8.5% to 8.2% while at the same time have raised the inflation forecast from 6.6% to 7.5%, says the report. There is a moderation in business expectations and some have also indicated a possibility of a slowdown, the report says. Other than inflation, currency risks, global economic instability and geo-political developments in the Middle-East and North Africa (MENA) are also affecting business confidence.

Surveys showed that the Indian manufacturing sector is concerned about the slowdown in overall demand conditions as rising input costs may result in higher prices for final products. Profit margins may also come under pressure with rising input costs. On the external front, though the earthquake in Japan is unlikely to have any significant impact on the economy, the risk of further worsening of the geo-political situation in MENA and a possible turnaround in global interest rate cycle would have to be factored into macro policies. Capital flows are expected to improve financing the current account deficit comfortably. However , the dominance of portfolio equity flows and the decline in FDI raise concern over the stability of capital flows, the central bank has said.