Jun 26, 2008

Inflation threat - Exaggerated ?

The rate of inflation has soared into the double digits. This has set alarm bells ringing. News channels beam the bad news into homes through the day and this creates a pervasive sense of gloom. Double digit inflation has been associated with the collapse of economic growth. Many wonder whether the present bout of inflation augurs the end of the high growth phase of the past five years. These apprehensions are unfounded. There is every reason to expect the rate of inflation to subside in the coming months although we may have to wait until September to see a meaningful reduction. Economic growth remains pretty much on track. Corporate earnings may see some slowdown but not as much as feared. These propositions need elaboration. To begin with the current rate of inflation, this certainly has to do with the base effect. In May-August 2007, the wholesale price index remained virtually unchanged going by monthly averages. At a time of rising food, oil and metal prices, this is bound to result in a spike in the inflation rates in the corresponding months this year. We are already seeing a moderation in food prices thanks to a good rabi crop, terrific success in food procurement and a slew of administrative measures. If the kharif crop turns out to be good, as is expected, food articles should cease to be a contributor to rising prices. Remember, it is a rise in food prices that are the primary concern to the vast majority of people and hence politically explosive. As for metal prices, we can expect a good portion of the rise to be absorbed by the end-user industries. India’s corporate sector has been growing profits annually at an incredible 45% over the past four years. There is enough room for end-user industries to absorb the increase in prices of intermediate products. That leaves oil prices. True, there is no dearth of doomsayers on this subject. But, as I argued a few weeks ago, the imbalance between supply and demand is still quite small - just 0.2% of overall supply. This imbalance does not justify the steep rise in oil prices that we have seen in recent weeks.
Moreover, we are seeing both consumers and producers respond to high oil prices. Demand is being curbed by prices being passed on, even if only partially, to consumers. Oil producers have committed to stepping up output. The big imponderable in the oil scenario is a US attack on Iran. Barring this eventuality, I stick to my earlier forecast that oil prices can be expected to drop to below $100 per barrel later this year. Many analysts see high inflation as provoking interest rate rises that will lead to a significant deceleration in growth. Most investment banks project GDP growth of under 8% for the Indian economy. These are dog days for investment bankers but what is bad for investment banking is not necessarily bad for the Indian economy. Because it reduces real interest rates, a rise in inflation is, in fact, a boon to those who have borrowed funds. Investors will become apprehensive only when they come to believe that high and variable interest rates have become entrenched in the economy. This requires quite a leap in imagination at the present juncture. The Indian economy has become investment-led since 2002-03. The surge in investment may be expected to underpin growth this year as well. The impact of the present adverse environment will be reflected mostly in lower earnings growth of companies. Most forecasts already show lower earnings growth but they ascribe this to a sharp deceleration in GDP and sales volumes. They are wrong. Earnings growth will slow down but this will be on account of lower margins, not lower sales, as firms try to absorb some of the increase in costs. This implies that a slowdown in earnings is built into the present forecasts; further downward revisions and the jitters in the stock market appear unwarranted. How should the authorities respond to the latest inflation figures? The current pessimism is misplaced, nevertheless there is pressure to ‘do something’. There is a case for monetary tightening but not entirely on account of the latest inflation numbers. Money supply has grown at 21% against the RBI’s target for the year of 16.5-17%. Prospects for the world economy look better in the second half of the year compared to those in the first half. This means that we can expect Indian economic growth to accelerate in the second half. If this happens, it could conceivably put the Indian economy in the ‘overheating’ zone, say, six months from now. Since an increase in interest rates takes effect with a time lag, now may well the time for some tightening. There is said to be debate within the UPA government over the timing of the next general elections. If the state of the economy is an important criterion, it makes sense to defer elections to next year. The news on inflation, growth and even the stock market promises to get better in the months to come.

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