The Re’s both good news and bad news from the price front. The good news is that inflation seems to be stabilising with the September number only marginally higher than the 8.5 per cent in August. More importantly, manufacturing product inflation, often described as core inflation by economists, has continued its downward trend. From 6.4 per cent in April, factory price inflation is down to 4.6 per cent in September. A favourable base effect kicks in from November — if food prices soften a tad and manufacturing inflation sticks to the current path, inflation could end up around 5.5 per cent by March 2011. The bad news is that the price level remains high. Wholesale price inflation for the month of September printed at 8.62 per cent, much higher than the Reserve Bank of India’s (RBI’s) target of 5.5 per cent. Despite what appeared to be a bountiful monsoon in most parts of the country, food inflation (and indeed agricultural products inflation on the whole) remains recalcitrant. Thus prices of food articles rose by 15.7 per cent in September over last year, while non-food primary articles’ prices increased by a whopping 18.2 per cent. Most economists agree that monetary tightening can hope to impact only on core inflation; curbing non-core inflation such as rising food prices is the remit of supply-management policy. Thus the current pattern of inflation would suggest that monetary policy has been somewhat effective in doing its job.
This should give RBI some elbow-room to exert itself in another domain that needs urgent attention, namely the foreign exchange market. The continuous rise in the rupee, spurred on by relentless portfolio inflows, threatens to damage export competitiveness and left unchecked, would start impinging on growth. RBI, to the surprise of many analysts, has been reluctant to buy dollars from the market to stem the rupee’s rise. One possible explanation has to do with the fact that when it intervenes in the currency market, it buys dollars and in the process sells or releases rupees into the economy. Given the link between inflation and excess liquidity, releasing rupees might not be a wise thing to do when core inflation is on the rise. Indeed, RBI has through a series of measures (raising the cash reserve ratio, curtailing its bond-buyback programme in the wake of the 3G auction related liquidity tightness) maintained a liquidity shortage in the market since May this year. Heavy intervention in the currency markets would have infused rupees into the system and compromised the objective of keeping money tight. With inflation stabilising, RBI’s degrees of freedom increase and it might be able to “intervene” more effectively in the foreign exchange market without fretting too much about inflationary consequences of enhancing domestic liquidity. The same holds for policy rates. While a hike in the repo rate or reverse repo rate sends a strong anti-inflation message from the central bank, it also widens the rate differential between India and the low-interest economies of the developed world, attracting capital in the process. Thus when it reviews its monetary policy stance on the second of November, RBI might want to keep the exchange rate in mind and maintain status quo in rates.