To become a textbook inflation targeting central bank, the Reserve Bank of India (RBI) has miles to go before it can sleep. Printing at 8.6 per cent for September, wholesale price inflation remains way above the central bank’s target of 5.5 per cent. Food price inflation remains stubbornly high and its very persistence seems to suggest that it can no longer be dismissed as a supply-side problem. Rising rural demand seems to be playing a role in food inflation, particularly in shoring up the price of things like milk, fish, fruits and vegetables. (These are items that would typically see a rising share as the rural consumer’s consumption basket gets “gentrified”). The bottom line is that the central bank needs to worry about food prices as well and cannot just lob the ball across to the supply-manager’s court. Thus, from a purist’s perspective, more tightening in the RBI’s monetary policy review on November 2 would be imperative.
However, monetary policy stance is often determined by whether one views the proverbial glass as half-full or half-empty. The less doctrinaire among analysts would actually claim that there are enough reasons for RBI to actually take a pause. They argue that while the absolute level of inflation is high, it seems to be headed southward over the rest of the year. Thus, by March 2011, the inflation rate could converge to the RBI’s target level of 5.5 per cent. For one, core inflation (manufactured products, excluding food items) has stabilised at about 5 per cent and its sequential pattern suggests further moderation by the year-end. Domestic commodity prices have softened on the back of an appreciating rupee and the bountiful monsoon this year is bound to have supply-side impact on agricultural prices, demand issues notwithstanding. Besides, a favourable base effect kicks in from November and that should lend a hand in pulling prices down. Domestic growth on the other hand seems to be entering a phase of consolidation. While the government’s official index of industrial production has been too volatile to suggest a trend, other indicators like the purchasing manufacturer’s index and anecdotal evidence on things like private capex activity suggest that industry is likely to lose some traction going forward.
Moreover, RBI’s relentless rate hikes over the past few months (an effective increase of 275 basis points in policy rates) and tight liquidity have seen a number of banks push up deposit rates. Lending rates are bound to increase in the next few months. Thus, the “transmission” of RBI’s policy rate hikes to actual borrowing and lending rates in the economy will become more visible in coming months. Hence, RBI could afford to step back a little and see how these changes pan out and impact on inflation. Finally, there is the risk of rupee appreciation on the back of an interest rate increase. Some may argue that a small increase in policy rates (say a quarter of a percentage point) should not make much of a difference to the exchange rate. But at a time when the global financial markets are inordinately bullish on emerging market currencies, even a small tweak in interest rates could lead to further appreciation pressure. This could work through the offshore markets that are often quicker at pricing in policy changes and could then feed through into the local markets. Semantics are just as important as anything else in communicating monetary policy. RBI needs to emphasise that it is merely pausing in November, not necessarily coming to the end of the cycle of raising rates. This would give it the much-needed breathing space to assess the current local and global economic situation without compromising on its role as inflation fighter.