Two broad scenarios seem to be emerging for the Reserve Bank of India’s (RBI’s) mid-quarter review of monetary policy on September 16. If RBI raises the repo rate, will it hint that it is either done with, or nearing the end of, tightening? Conversely, if it favours a wait-and-see approach, say, because of the deterioration in the global backdrop, will it guide that it is not done with tightening? There is a mistaken notion in India that a pause in one policy review means the end of tightening or tight money. This is perhaps an inadvertent outcome of RBI’s work-in-progress communication style and a conditioning of expectations following back-to-back rate hikes. The central bank should guide to correct this lopsided conditioning.
However, there could also be a third scenario. The upcoming review is an inter-quarter “mini” policy in which only a short policy statement will be issued; there will be no forecast revisions and no media interviews. Consequently, a significant change in stance seems less likely. Unless it disappointingly succumbs to remote-controlled pressures, RBI’s own hawkish guidance and the close to double-digit inflation suggest that a rate hike should be the default outcome. It will acknowledge the worsening global backdrop, but perhaps leave any meaningful shift in guidance for the mid-year review in October. Given the multiple uncertainties, RBI cannot signal just yet that it is done with tightening.
Whatever the embarrassing shortcomings in measuring inflation in India and the flaws in relying on the wholesale price index (WPI) for calibrating monetary policy, inflation continues to be perceived as being exceptionally high. It should not be difficult to figure out why households’ inflation expectations have not eased, despite a cumulative increase of 475 basis points (bps) in policy rates since early 2010. Among other factors, the still-high food inflation plays a big role in affecting households’ inflation expectations.
Higher interest rates – no matter how necessary to check aggregate demand and core inflation – alone cannot soften households’ inflation expectations. In fact, recent monetary measures are more than just about managing the economic cycle; they are also making up for the government’s quadriplegic-like approach. Indeed, even RBI appears to have thrown in the towel: it indicated in the July policy that one of the expected outcomes was to “reinforce the point that in the absence of complementary policy responses on both demand and supply sides, stronger monetary policy actions are required”. The fiscal over-run is another example of what has made monetary policy less effective. Ironically, the government can’t do what it should do, but reportedly won’t let others do what they want to do.
The argument for staying on hold because the impact of previous rate hikes has not been fully felt has some validity but the same argument could have been used at earlier reviews, two of which actually recently resulted in bigger 50-bp hikes. The headline WPI inflation possibly rose in August — hardly an outcome for RBI to switch off just yet. Also, potential inflationary pressures from addressing “suppressed” inflation cannot be ignored. Thus, at least one more rate hike is warranted. India cannot take any lead from Brazil’s unexpected rate cut since the situation in the two countries is dramatically different.
The ongoing moderation in economic activity is not new and is going to gain traction. But growth deceleration is precisely what monetary tightening is meant to achieve in order to check inflation, although government’s policy paralysis also has a meaningful role to play in this deceleration. There is a strong possibility that gross domestic product (GDP) growth for FY12 will be in the seven to 7.5 per cent range, below the first-quarter FY12 GDP growth of 7.7 per cent and lower than RBI’s guidance of eight per cent. But that is the price for checking inflation, especially in the absence of any meaningful government actions.
Strangely, for a central bank trying to slow the pace of aggregate demand to check inflation, RBI’s own GDP growth forecast of eight per cent implies a pickup in the growth momentum later in the year. This is despite the fact that the full impact of monetary tightening has yet to be felt and the global downshift will have a more pronounced impact in the second half. Indeed, even if increased (constructive) policy activism facilitates a revival of investment, that pickup will only add in the near term to the very aggregate demand that RBI is trying to moderate.
More From This Section
The global disinflationary environment will favourably affect India’s inflation as well, but we are not there just yet. Crude oil price still doesn’t offer any sustained comfort and the potential impact of a third round of quantitative easing (QE3) cannot be ignored. However, two aspects should be noted: (1) as and when it is announced, QE3 will probably be open-ended, unlike QE2; and (2) QE3’s impact on risk appetite and hence commodity prices might be more muted than QE2’s because of the conditions in Europe, which are significantly worse than what prevailed at the time of QE2. Consequently, a relatively weaker euro could check the one-way bearish bets on US dollar, which in turn could result in a more muted global asset inflation cycle. Also, global growth now is on a much weaker footing than was the case at the start of QE2.
RBI should also consider how long it would want to keep the repo rate unchanged once it gets to an appropriate level. The anticipated inflation trajectory will play a crucial role, but hopefully RBI appreciates that, barring a crisis, central banks normally have a period of status quo between tightening and easing policy.
Just as RBI reportedly avoided even bigger rate cuts in 2009 in order to refrain from having to undertake an even earlier upturn in the rate cycle, the same consideration will soon be a useful guide. There is merit in maintaining rates at high level (say, another 25 bps from the current repo of eight per cent) for longer than to raise more than that from here and then ease quickly. As it is, barring another sustained leg-up in commodity prices – in which case RBI’s and market’s inflation and interest rate forecasts will go for a toss – the possibility of easing before the middle of next year should not be ruled out.
The author is senior economist at CLSA, Singapore
The views expressed are personal