As the Reserve Bank of India (RBI) gears up for its quarterly monetary policy announcement tomorrow, several key economic indicators point in opposite directions. These therefore present the RBI with the choice of persisting with the aggressive anti-inflationary stance that resulted in two sets of repo rate and cash reserve ratio (CRR) hikes last month, and stepping off the pedal while those measures are allowed to work their way through the system. Several recent developments do support a wait-and-watch announcement tomorrow. The most significant of these is the rapid decline in oil prices over the past 10 days. Significant softening of demand in the US, combined with recent announcements of increases in domestic fuel prices by China, India and other Asian countries, has undoubtedly contributed. As growth in global consumption slows, prices must come down too if supply is not disrupted. Oil at $120 per barrel is still very costly, but the recent dip has quelled fears that the price will go nowhere but up. Domestic indicators also point to the monetary tightening of recent quarters having the desired impact on economic activity. Industrial growth has slowed sharply, led by interest rate-sensitive sectors. Of particular concern is the very sharp deceleration seen in the machinery and equipment segment in the May numbers, suggesting that investment activity is turning sluggish. As far as financial markets go, interest rates across the board clearly reflect the relatively tight liquidity situation. Under these circumstances, further tightening may exacerbate an already delicate situation, making it more difficult to trigger a recovery when the opportunity to start reducing interest rates emerges.
However, there are also factors that argue in favour of persistence with the tightening programme. The inflation rate is still way beyond tolerance limits and is likely to stay there for some months. Even if oil prices are declining, domestic prices are still much below full pass-through levels. This means the underlying inflation rate is still being under-estimated. To add to the pressure, the monsoons clearly have not been as prolific as the forecasts indicated. The prices of some critical crops in the pulses, oilseeds and coarse grains categories already reflect this. This means that the inflation rate may rise even higher in the coming months. On the liquidity front, a significant contributor to the recent tightening was the outflow of capital, particularly from the equity markets. In the aftermath of the trust vote, there has been some reversal of this trend, and the inflows will continue if the government initiates some of the reform measures that it has been talking about. This would warrant a hike in the CRR to offset the increase in liquidity, though not necessarily a hike in the repo rate.
So, which way should the RBI lean? On balance, having made a strong commitment to an anti-inflationary position in its off-schedule announcements in June, there is merit in staying with that position and tightening further in tomorrow’s announcement. This will reinforce the credibility of its stance and contribute to speeding up the adjustment process, which is already in motion. The dominant perception amongst central banks around the world currently is that the inflation risks significantly outweigh the growth risks. Indeed, both the Confederation of Indian Industry and Federation of Indian Chambers of Commerce and Industry have just held the meetings of their national or executive councils, and both report continued growth optimism among the captains of industry, albeit with reduced profit margins. If inflation therefore remains the primary danger, it should provide the basis for tomorrow’s announcement.
