Executive Director, JPMorgan Chase Bank, Singapore The Reserve Bank of India must tighten policy to anchor inflation expectations and to check the second-round impact of higher input prices |
Fuelled by sharply higher international prices of oil and non-oil commodities including food, WPI inflation has shot up to a level that RBI Governor YV Reddy has justifiably labelled "unacceptable high". Politicians are in full damage-control mode: calls for interest rate cuts have disappeared, and the government has already responded with some fiscal measures. |
But what about the RBI's response? Inflation is well above its comfort level of 5 per cent year-on-year, and the underlying causes of the surge are mainly foreign supply-side in nature. Essentially, India is getting whacked by an adverse terms of trade shock that is overlapping with softer external demand and, in all likelihood, a significant slowdown in capital inflows. Not doing anything is not an option for the RBI, in my opinion. Still, there is a limit to what monetary policy can achieve when there is little complementary progress by the government on the long overdue reforms, especially in agriculture. |
The RBI must tighten policy to anchor inflation expectations and to check the second-round impact of higher input prices. It can hike policy rates, increase the cash reserve ratio (CRR), or appreciate the rupee, or a combination of the above. A policy rate hike is unlikely to be the first line of attack, as the high interest rate differential is already problematic. Also, investors' expectations of interest rate have undergone a major shift towards tightening, thereby lessening the immediate need for a rate hike. |
Liquidity management will be the key focus of the RBI, and a 50bp CRR hike is likely, either in the run-up to or at the April 29 policy. The hike will probably be complemented with hawkish comments that won't rule out further action. Overall, a CRR hike offers a palatable balance between being seen as taking action without overdoing it. I doubt if the central bank will hike CRR and policy rates in one go. |
Unlike other Asian economies, India runs a current account deficit that is worsening at a time when, unlike last year, there is high degree of uncertainty over the direction and magnitude of capital inflows. Also, rupee appreciation may not have a lasting impact on inflation (for example, last year's experience), while it will surely hit exporters, especially IT-related, at a time when they are already dealing with softening external demand. |
Any whiff of policymakers favouring rupee appreciation will increase the speculative capital inflows wanting to capitalise on a stronger rupee, thereby possibly making the appreciation self-fulfilling. The last thing they need to do is to hint at a preference for appreciation but be ill-prepared for the ensuing appreciation and its consequences. Hopefully, the government has learnt something from the political and economic fallout from last year's outsized rupee appreciation. |
Director and Principal Economist,
CRISIL Ltd
Hiking interest rates works only when there is excess demand. In this case, the problem is the supply side. Hiking rates will only lower growth