The upcoming policy review of the Reserve Bank of India (RBI) on November 2 is the first time since the central bank began its exit late last year that there is a strong case for it to pause. At the very outset, a pause does not mean the end of the tightening cycle or that the central bank is taking its eyes off inflation. It essentially offers a breather to take stock of the emerging domestic and external trends, as the incoming data are becoming more two-directional after being unidirectional over the last year or so. A pause also allows the RBI to buy time for its recent aggressive moves to be effective, and to avoid accidental over-tightening relative to the incoming indications about economic activity.
In its last policy statement, the RBI indicated that it was near the neutral rate and that future actions will be affected less by the need to normalise and more by the evolving growth-inflation trade-off. Given the lack of consensus or clarity on what the correct — or even an appropriate — level of the neutral rate is for India, the RBI could be either at the neutral rate now (with the repo rate at six per cent) or 25-50 basis points away from it. Given that the RBI now announces monetary policy approximately every six weeks, it surely cannot be raising rates at each review.
More important for the upcoming policy are issues such as the outlook for inflation and growth and whether the monetary actions so far are already beginning to pay dividend. Monetary policy changes deliver results with lags, hence central banks have to be mindful of not overdoing the tightening.
The RBI has cumulatively raised policy rates 275 basis points beginning with the first increase in March, as it moved to normalise the monetary setting following a successful and aggressive easing to soften the hit from the global credit crisis. With the exception of a 25 basis point increase each in March and April, the remaining increase in rates was packed in the July-September quarter, as the RBI also shifted its operational policy rate to the repo rate from the reverse repo rate.(Click for graph)
The change in the operational policy rate is an aggressive tightening by “stealth”. Also, the recent rate hikes were complemented with a sizeable deficit in the liquidity adjustment facility (LAF), and with currency appreciation. The bottom line is that monetary conditions tightened significantly in the July-September quarter, and the full effect of these moves has not yet played out.
More From This Section
But real economic activity is already rolling over, even if the industrial production data exaggerate that moderation. Also, the strength of the upturn in private investment is not yet what it should be. In any case, banks are poised to raise their rates further after Diwali, which will in turn affect economic activity, as it is expected to. Indeed, banks have yet to fully transmit the effect of the RBI’s moves, but it is coming. However, the RBI should focus more on the worrying speculative trend in the real estate market that is partly being fuelled by innovative borrowing plans.
The RBI’s monetary tightening is yielding positive result in fighting inflation. Indeed, seasonally-adjusted data unambiguously show that inflation, including that in non-food manufactured goods (or core, which is what the RBI can really affect), is coming off. This trend will begin to be captured to a bigger degree in the year-over-year (YoY) comparison in the coming months.
The seasonally-adjusted pattern is remarkable enough that the RBI should not ignore it. Also, the rolling over in economic activity already visible will further ease demand pressures at the margin. Admittedly, the YoY WPI inflation rate remains high at 8.6 per cent, but even this has eased from 11 per cent in April. The core WPI inflation has eased to five per cent YoY from close to six per cent in April, and the RBI appears on track to meet its WPI inflation forecast of six per cent for March 2011. While the current level of inflation rate is relevant, the expected inflation trajectory should be an important input in deciding the next step.
India’s food inflation has two different dynamics at play. One, an increase in food items rich in protein (such as meat, fish, eggs) that has partly been driven by the government’s own active policy of improving the disposable income of the poor. There is little monetary policy can do to correct this structural increase. In fact, it would be counter-productive for the RBI to target this as it is an intended result of the government’s policy. The correct approach would be for the government to enhance supplies.
Two, the rise in the prices of food items that is dependent on the monsoon. Given that the monsoon rainfall has been good, the prices of many of these items should ease as the harvests hit the markets. In the final tally, the food inflation rate, which has already halved, is likely to ease more meaningfully over the next two months.
What about the impact on inflation of rising global commodity prices? This is a legitimate risk. However, these prices are rising not because of improving global growth but because of the same reason that is causing a surge in capital inflows in emerging economies: the weakening US dollar and easy global liquidity. Several emerging economies are talking about restricting capital inflows, but seem unclear about how to deal with rising commodity prices. In the current setting, they are more effectively tackled by currency appreciation rather than by interest rate increases, as the latter will hurt domestic-driven growth and attract even more capital inflows. Currency realignment (read appreciation) in emerging economies is an important part of fixing the broader global imbalance. Restricting capital inflows does not do anything to the transmission of that rebalancing via higher commodity prices.
Unfortunately, there continues to be a severe lack of full appreciation about the fact that the actual monetary conditions now are much tighter than what the repo rate of six per cent indicates. Market rates are much higher than what would normally be hinted by the current level of repo rate. The current combination of the repo rate and the LAF deficit makes for a much more aggressive policy setting than was the case when the repo rate was at six per cent, say, in early 2005. Further, raising rates a day after Bernanke formally begins QE2 only increases the risk of attracting even more volatile foreign capital into India.
Thus, there is a strong case for the RBI to pause now but maintain a hawkish stance rather than raise rates by another 25 basis points and then go on hold. There is little to gain from another rate hike at this point but potentially more to lose. Remember that winning the inflation battle by crippling growth is not on the agenda.
The author is senior economist at CLSA, Singapore. The views expressed are personal