Few options for RBI as India loses grip on inflation

India is risking losing control of inflation, leaving the Reserve Bank of India (RBI) with few tools other than the blunt instrument of more aggressive interest rate increases even as growth momentum slows.

The near-9% annual rise in the March headline inflation rate reported on Friday and a sharp upward revision in the January figure stunned investors and fuelled calls for tougher rate action by the RBI. In addition to more hawkish language, the central bank may lift rates by 50 basis points (bps) at its May 3 policy review, twice as much as expected earlier, or more likely increase the number of times it will raise rates in its current tightening cycle.                                     

     
"They have to move by about half a percentage point in the May policy to signal to the market that they are trying to catch up to the curve," said Abheek Barua, chief economist at HDFC Bank in New Delhi.                                           

Although most market players said they still expect the RBI to stick with its usual 25 bps point move, the 1-year overnight indexed swap has risen more than 25 bps since last week's inflation data, implying expectations for an added rate hike over the next year. The yield on the 7.8% 2021 bond is up 8 bps over the same period.                                           

The RBI has raised rates eight times since March 2010, even as inflation for the past year has been driven mainly by the prices of food, as well as energy and other global commodities that it can do little about. Fast-growing India is prone to inflation after years of under investment in everything from power and roads to agriculture and education, which creates capacity constraints that will take years to rectify and leave the economy vulnerable to shocks like a bad harvest or a spike in coal prices.                                           

"India needs to address several structural reform issues on a priority basis to make monetary policy more effective. The ultimate solution for the current inflation problem is not within the control of the RBI alone," said Rupa Rege Nitsure, chief economist at Bank of Baroda.                                          

However, core inflation, driven by demand of the sort that is more receptive to monetary fixes, has also been on the rise in Asia's third-largest economy, hitting a 29-month high in March, according to Barclays. This may compel the central bank and its mild-mannered governor, Duvvuri Subbarao, to shed its oft-stated 'calibrated' approach to monetary tightening and make a bolder gesture.                                                                                   

Unlike China, which has been raising reserve ratio requirements for banks to tame inflationary lending, India is unlikely to pull this lever, with liquidity already tight and the government's need to fund its borrowing programme. Meanwhile, the likely increase by the government in diesel prices once elections in a handful of states are completed next month will only add to near-term inflationary pressure.                                           

Diesel in India sells at 30% below cost, according to Standard Chartered, which said a 5% increase in the fuel price could add about 30 bps to headline inflation, not counting knock-on effects.

Standard Chartered on Monday doubled its prediction for rate rises for the remainder of 2011 to 100 bps from 50, while Barclays raised its forecast to 75 bps of increases by September, from 50 bps earlier.                                       

   
"Tightening monetary policy to engineer a soft landing is a better option than allowing inflation to persist and risking a hard landing at a later stage," Standard Chartered economists wrote, lifting their average inflation forecast for the fiscal year that started this month to 8.4% from 7.9%.                                          

Beyond raising fuel prices, the growth-obsessed government is unlikely to implement new fiscal restraint, leaving it to the RBI to manage the aftermath of financial crisis-era stimulus and other programmes that have helped fuel demand, especially in rural areas.                                           

"Other than rate hikes, not many options are available to the RBI as liquidity is tight and expected to tighten further," said Sandeep Bagla, senior vice president at ICICI Securities Primary Dealership in Mumbai.                                  

        
While the March inflation figure surprised every forecaster, the fact that the RBI's own prediction was so far off also hurt its credibility. It raised its outlook for end-March inflation to 8% on March 17, adding to upward revisions it made in November and January.                                           

"At this stage I think the RBI is seriously concerned about its credibility, and the fact that inflation expectations are getting sort of revised up to a permanently high level," said HDFC Bank's Barua.

RBI action will, however, be tempered by signs of weakness in India's growth story, including sluggish investment activity and industrial output. Almost no private economist shares New Delhi's view that India will grow at 9% in the fiscal year that started this month. Rather, many predict a decline from last year's growth of about 8.6% to below 8%.                        

                  
In addition to an economy running up against capacity constraints, the impact of the RBI's tightening programme is starting to bite, raising the cost of capital. The central bank has also expressed concern about sluggish investment.

Robert Prior-Wandesforde, an economist with Credit Suisse in Singapore, said slowing growth is what India needs."In my view, the overall policy stance, particularly what's happened to interest rates, is now enough to send growth below trend. India does require now a period of sub-trend growth to alleviate these bottlenecks, these constraints," he added.