The Reserve Bank of India (RBI) is due to announce the monetary policy for this fiscal on May 3.
The backdrop against which the central bank will formulate this policy presents a dilemma. While the focus of the policy action is clearly on controlling the rampant inflationary pressures, the central bank will have an eye out on the softening growth momentum.
The central bank would therefore look to remain hawkish to curb inflation, but is unlikely to step up its calibrated pace of monetary tightening of 25 basis points (bps).
Wholesale price index (WPI) inflation data for March reiterated the strength of inflationary pressures in the economy. Not only was the headline rate almost 1% higher than the RBI forecast, but also core inflation (based on non-food manufactured products WPI) jumped back to 7%, from 6.1%. The average WPI inflation for 2010-11 fiscal went up to 9.4% from 3.6% in the previous fiscal.
For most of the previous fiscal, supply side pressures were strong and emanated initially from the food articles and products and in more recent months from rising crude oil prices.
The situation on inflation has been complicated by the fact that demand conditions in the economy have been strong. As a result, manufacturers, faced with rising input costs along with capacity constraints, have been able to push up their output prices. This improvement in the pricing power of the manufacturing sector is visible in the spiral in core inflation. Besides, stronger growth has once again exposed the infrastructure and other supply bottlenecks in the manufacturing sector. The RBI, therefore, has reasons to worry about inflation emanating both from supply as well as the demand side as it embarks on setting the monetary policy.
Since this is the annual policy announcement, the RBI will also present its assessment on the growth scenario this fiscal. Growth momentum is slowing down. Recent data suggests that while private consumption and external demand are holding up, investment activity is slowing down. Going forward, a combination of high inflation and rising interest rates would adversely affect consumption and slow down growth further. The sharp increase in crude oil can be another dampener to the growth momentum as higher fuel costs would negatively affect consumption spending and adversely affect the manufacturing sector.
On the positive side, global growth conditions remain supportive. Importantly, the prospect of a normal monsoon is crucial for a normal year for the farm sector, which in turn is crucial for keeping a lid on food inflation.
The RBI would be particularly concerned about the slowing investment activity as that has longer-term implications given that capacity constraints add to the inflationary pressures over the long run. Extremely tight liquidity conditions and a sharp increase in funding rates are adding to the other factors negatively affecting the investment climate in the country. Hence, any further tightening of monetary levers would have to consider the risk of slowing investment growth more seriously.
In formulating a policy response in this back drop of high inflation and slowing growth, the RBI will be mindful of the fact that bank lending rates and other market rates have risen sharply in response to its rate hikes over the last one year. That would in due course slow down consumption and help curb the demand side pressures on inflation.
The need for some more tightening is, however, quiet clear given the persistence of inflationary pressures. A partial pass-through of higher global prices to local fuel prices is almost certain over the next quarter. Headline WPI inflation can remain in the 7-8% range until November 2011.
However, moving away from a calibrated pace of tightening, i.e. 25 bps rate hike in each meeting, and becoming more aggressive is not required at this stage at least.
After raising rates by 25 bps each over the next two policy meetings (May and June) the RBI would have to reassess the strength of demand conditions. Any further tightening would depend on the outlook for growth and inflation.
Here, the RBI would pay particular attention to the pace of non-food credit off-take, especially the increase in banks’ retail lending. Retail lending momentum picked up sharply in the last fiscal (16.2% yoy growth compared to 4.1% yoy growth in the previous fiscal) and if that momentum persists, then the demand side pressures would be further reinforced.
The new operating procedure for monetary policy is also likely to be adopted very soon. Under this new regime, the RBI would look to maintain deficit liquidity conditions in the banking system and target only the repo rate. The other rates would be linked to repo rate. This new mechanism is aimed at making monetary policy transmission more effective by maintaining a “deficit” liquidity regime. That, as was seen in the previous fiscal, would help in swifter response from banks in adjusting lending rates in response to the policy signals from the RBI. This, in turn, would give more time to the central bank to consider all possible risk before altering its monetary stance radically. Clearly, the risk of monetary conditions becoming too tight and adversely affecting growth much more than required is to be considered with each rate hike post another couple of rate increases.
The writer is senior economist, Royal Bank of Scotland NV, and can be reached at gaurav.kapur@rbs.com. Views are personal.
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