The key issues for the Reserve Bank of India in its upcoming monetary policy review for 2011-12 will likely be dissecting the growth-inflation trade-off, taking a closer look at demand- versus supply-driven factors affecting inflation, and deciding whether to raise the policy rates by 25 or 50 basis points (bps).
On the surface, it appears puzzling that wholesale price index (WPI) inflation continues to be higher than expected despite a hefty cumulative increase of 350 bps in policy rates since early 2010 and increasing indications about moderation in growth.
However, a little bit of digging reveals that there is no puzzle (more on this later).
In my opinion, the RBI's forecast for GDP growth for 2011-12 will probably be in the 8.0-8.3 per cent range, while the WPI inflation for March 2012 will be pegged in the 5.0-6.0 per cent range.
The actual inflation outcome will probably be higher but the RBI is unlikely to announce that just yet and the high base for March 2011 will flatter the year-on-year comparison for WPI in March 2012.
Judging the growth-inflation trade-off accurately is more crucial than ever before, as is analysing the drivers of inflation.
The RBI has actually been successful in managing aggregate demand but the supply-side nature of inflation (including higher global commodity prices and the delayed changes in local administered prices) is what is surprising on the upside.
My own sense is that demand-side factors have become less important than supply-side factors in contributing to inflation.
Growth is already moderating and aggressive rate increases from here on will risk a far greater slowdown than what is needed, especially since monetary measures work with a lag and we have not seen the full impact of the tightening done so far.
Car dealers are reporting a slower off-take owing to several factors, including higher interest rates, and the investment upturn is weaker than expected.
Also, the pace of monetary expansion is not excessive and the current credit growth mainly reflects higher working capital (as input prices have increased) rather than stronger aggregate demand.
There is a lot of noise that real interest rates in India are negative and are contributing to inflation. While it is true that real policy rates (as measured by WPI inflation) in India are negative partly owing to the nature of supply shocks, real lending rates, which matter for aggregate demand, are well into positive territory.
The picture also changes if one buys the argument that using WPI in place of an accurate consumer price index (CPI) overstates inflation.
Indeed, credit growth would have been a lot higher and economic growth would not be decelerating if real lending rates were very attractive for borrowers to cause a lending boom.
The run-up to the policy review offers a good time to question the RBI's choice of the WPI as a key measure of inflation when the practice throughout the world is to use the CPI.
Indeed, it is a mistake to use the WPI as a replacement for the CPI, which is what it has emerged to be for policy purposes and for market participants in India.
The distinction between the two has become more important owing to the sharp upturn in global commodity prices that impact input price inflation far more than final goods prices as captured by CPI inflation.
The latter is what central banks actually attempt to manage by affecting aggregate demand. Either the central bankers in the rest of the world have got it wrong or the RBI has it upside down and needs to explain the unique tools it has to manage input price changes.
But whatever the compulsions of using WPI as a key metric of inflation, it is a faulty measure for deciding interest rates.
Actually, India's unique focus on WPI when global commodity prices are rising probably overestimates the underlying inflationary pressures, even as higher commodity prices will keep inflation higher for longer, essentially a new higher normal for inflation.
Obviously, there is some impact of final consumer demand on input prices but it is unlikely to be 100 per cent of the pass-through of higher input prices that are captured in WPI inflation.
Thailand offers a good example (but not the only one) of inflation dynamics in an economy where the output gap has closed. In 2010, inflation measured by the producer price index (PPI) was 9.4 per cent but CPI inflation was only 3.3 per cent.
The Bank of Thailand (BoT) focuses on CPI, not PPI. If it focused on input prices like the RBI, the BoT's monetary policy would have been on a totally different -- and incorrect -- trajectory.
The RBI's characterisation of higher non-food manufactured goods WPI (a crude measure of core input inflation, not core final goods inflation) as reflecting stronger aggregate demand affecting inflation is totally incorrect, in my humble opinion.
Indeed, higher global commodity prices and/or upward adjustment in domestic administered fuel prices will result in higher core WPI inflation, even if demand conditions remain unchanged or are weakening!
Should the RBI raise rates by 25 bps or 50 bps on May 3? The most bogus argument for a 50-bp increase is that it will restore the RBI's credibility -- not the first time we have heard that.
I'd vote for a 25-bp hike accompanied by a hawkish statement that accurately lays more emphasis on inflation now being less affected by demand-side factors owing to the ongoing policy response.
The RBI has rightly stayed away from a one-step 50bp hike so far in the current tightening cycle, and it is not necessary to alter that approach this late in the cycle, especially since it meets every six weeks. Also, we do not know how the monsoon is going to play out.
The RBI needs to act but it should not go overboard now even as it attempts to clarify its misconstrued focus on WPI inflation for setting interest rates.
Indeed, a risk-reward assessment still favours staying with a 25-bp increase. Financial stability in a topsy-turvy world remains important and we must avoid a repeat of the mid-1990s experience of killing inflation by killing growth.
The author is senior economist at CLSA, Singapore. The views expressed are personal.