RBI, North Block likely to diverge on post-policy path

The government has grudgingly accepted the central bank will likely lift interest rates on Tuesday, but is not convinced conditions warrant further tightening thereafter, official sources said.

While the Reserve Bank of India remains worried that inflation is being driven by demand-side factors that will require further action in coming months, New Delhi argues that a good summer monsoon will ease high food prices, and that slow growth in money supply undermines the case for further rate increases.

RBI governor Duvvuri Subbarao and finance minister Pranab Mukherjee were set to hold their usual Friday meeting ahead of the July 27 quarterly monetary policy review, at which the RBI is widely expected to lift rates by 25 basis points each and reiterate its stance of a “calibrated” exit from loose policy.

At issue is the source of inflation, which has been above 10% for the past five months. Initially driven by high food prices —- which are beyond the scope of monetary policy —- inflation has become more generalised.

“I frankly don’t think there is a need to raise rates right now. However, having said that, there are inflationary compulsions and we at the finance ministry are well aware of that,” a senior finance ministry official said.

The central bank, which has lifted rates three times since March by 25 basis points each, also prefers to take “baby steps” to protect economic growth momentum and does not want to deviate from its stated path of a gradual exit, which could unsettle markets. That said, it has been known for its penchant for surprise.

“In the current context, we also realise that we can’t afford to normalise rates aggressively. We have to be so-called behind the curve to build credibility. We have to take care of market sentiment,” said a central bank source involved with policy.

A quarter point rise next Tuesday would take the repo rate, at which the RBI lends to banks, to 5.75% and the reverse repo rate, which it pays banks when they deposit excess cash, to 4.25%.

While the RBI is not constitutionally independent, in practice it has the latitude to act when it deems necessary.
Subbarao and Mukherjee have tended to be on the same page on monetary policy, but not always. The RBI unexpectedly raised rates on July 2, a move sources say was against New Delhi’s wishes.

While a weak global recovery is one argument against further tightening in India, another is tight banking system liquidity that has acted as an effective rate increase of 150 basis points.

“When there is a persisting liquidity tightness in the markets, it has already perked up your call rates to around the repo rates, we need to examine what are we achieving by monetary tightening,” another finance ministry source said.

Adding to inflationary pressure is the government’s increase in fuel prices, which will add about one percentage point to wholesale price index (WPI) inflation starting in July.

“We need to first discount the fact that the fuel price effect is a one-off and the monsoons are also boding well, so after July 27, we need to be cautious on further monetary tightening,” a finance ministry source said.

While the RBI and finance ministry both acknowledge that more generalised inflation is a worry, New Delhi disagrees with the central bank on how sustained the impact of higher core inflation will be on the headline figure.

The central bank said alongside its July 2 rate hike that two-thirds of May inflation was contributed by non-food items.

“Please understand that when M3 (money supply) is just a little over 15% and credit growth is at 22%, I don’t think, at least on this front, this is fanning inflation,” a finance ministry source said.

The RBI has projected inflation to be at 5.5% by March-end, money supply growth at 17% and credit growth at 20% in the current financial year.

“If there is oversupply of money, it has necessarily to be handled by monetary policy instruments. But if there are other factors which are contributing to rise in prices or inflation, then it may not be a very useful tool, it may be somewhat blunt,” finance secretary Ashok Chawla told NDTV Profit on Thursday.

“The assessment from the finance ministry side is that there are also supply side bottlenecks that are causing inflationary pressures in the economy and beyond a certain point monetary measures do not help,” added a finance ministry source.

The RBI is not convinced the inflation outlook is benign.
“All depends on how strong the argument is. We will tell them (the government) that if inflation expectations solidify, it will push up government bond yields, loan rates will go up, and there will be a spiralling impact economy wide,” an RBI source said.