Column : Let’s not get ahead of ourselves
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Some might quibble that all-India CPI inflation rising above 10% in December was largely on account of an unfavourable base effect. That is true, but it's not just about December. Retail inflation—as measured either by the all-India CPI or Industrial Workers CPI—has been close to double digits through all of 2012. To be sure, the momentum has tapered in recent months, but is still uncomfortably high. And the divergence between WPI and CPI inflation is understandable given the cost-push nature of inflation over the last two years.
Finally, what's also important to realise is that the current account deficit (CAD) continues to deteriorate even as non-oil and non-gold imports are on course to contracting this year as demand has slowed. If RBI were to slash rates to jump-start growth, the current account would suffer from a double-whammy—rising gold imports from lower deposit rates and rising non-oil and non-gold imports as consumption and demand re-accelerate. This is likely to offset any gains from exports and keep the CAD near 4% of GDP.
Can India continually finance such a deficit? Only in a perfect world, where global liquidity is awash, tail risks around the globe are minimised, and policy at home remains continually constructive. But if any one of these factors gives, we could be back to August 2011 or May 2012—where the combination of a sudden stop in capital flows and a bloated CAD puts the rupee under enormous pressure, and helps spark another bout of inflation.
The bottom line is that the current moderation in inflation pressures is unlikely to sustain unless the true underlying causes are addressed—a structural deterioration in investment and the fiscal deficit since the Lehman crisis. Only aggressive de-bottlenecking of supply-side constraints can boost the economy's potential and keep core inflation contained in the medium term—as we experienced in the mid-2000s. And only when the fisc corrects will the current account follow and the pressure on the currency abate. To be fair, the government has demonstrated intent in addressing these issues in recent months. But unless policy measures are taken to their logical conclusion, 2013 could look very much like 2012: some easing at the start but a central bank left with very little room to manoeuvre thereafter.