All eyes are on the Reserve Bank of India’s (RBI) mid-quarter monetary policy review on March 17. It has so far been aggressive in its actions, having raised policy rates seven times, and effectively increasing rates by 325 basis points (bps) since early 2010. The actual monetary transmission has been even more potent since market rates have been well above the repo rate owing to tighter liquidity conditions, even if we discount the fact that banks woke up late to transmit the hikes in policy rates.
The RBI will probably raise rates by 25 bps and stay the course with the hawkish bias. More open to debate is how much more aggressive is the RBI poised to be here on, as economic growth is most likely to moderate in 2011-12 even as trend inflation will be higher for longer. A gross domestic product (GDP) growth of 9 per cent in the next fiscal year despite an even more aggressive RBI appears to be an extremely low-probability outcome. Moreover, given the global dynamics in commodities, more adjustments in local prices are likely, which, in turn, will sustain core inflationary pressures.
India’s improving headline inflation trajectory for much of calendar 2010 that followed from the severe drought of 2009 was thrown off course in December by the unexpectedly large hit from the fresh fruit and vegetables component of the wholesale price index (WPI). After hitting a high of 11 per cent year-on-year (YoY) in April 2010, WPI inflation eased to 8.1 per cent YoY in November, before reversing course to 8.4 per cent in December. The food composite index (weighted average of food components of the primary and manufactured goods subindices of the WPI) jumped in December to 8.6 per cent YoY after having declined to 6.8 per cent in November from 20.2 per cent in February 2010. Partly owing to government measures and improved supply, food inflation began to ease from the second-half of January. Indeed, the February WPI food inflation rate is likely to show a significant decline, though core inflation will rise.
Despite the reams that were written on the jump in food inflation being triggered by improving affluence and existing structural deficiencies, one of the key drivers of the jump in inflation in particular was the fruit and vegetable category. The surge in the prices of that category alone contributed a massive 1 percentage point to the 8.4 per cent YoY inflation rate in December. It can’t be denied that a risk of a structural demand-supply imbalance in the food economy remains, as policy initiatives have not enhanced agriculture productivity even as higher incomes have boosted demand. But this risk is not entirely new, and still asserts itself mainly via amplification of the impact of supply shocks, such as poor monsoons. However, the government needs to get its act together on this important issue.
It is often overlooked that India’s food inflation is not correlated with global food inflation. The claim by some that a good monsoon last year did not have a favourable impact on food inflation is incorrect, since food grain shows no pressure points owing to improved supply. So far, most of the structural pressure on food inflation has been concentrated in protein-rich food items such as eggs, meat and fish, and milk, which have been affected by improving demand and inadequate gain in supply. Indeed, eggs, meat and fish and milk categories together contributed half of the 8.6 per cent YoY increase in the food composite in December.
While food inflation is softening, core (in India’s case non-food manufactured goods) inflation is likely to increase, especially owing to the pass-through of higher global commodity prices to local prices. Depending on the magnitude of the pass-through, inflation and the government’s subsidy bill will be higher. While sensible economics dictates that the pass-through should happen, the schedule of state legislative elections suggests that a hike before that won’t be preferred, but some action thereafter is highly likely.
The RBI’s focus on WPI rather than the consumer price index (CPI) inflation means that core inflation will be quicker in adjusting upwards owing to the pass-through of higher commodity prices. The central bank is essentially trying to target prices of inputs and tradeables rather than final goods prices. Core inflation has already seen an uptrend in seasonally-adjusted sequential terms, but the RBI’s response appears to be more geared to the YoY inflation rate, possibly because that is what the public identifies with and reacts to.
Higher crude oil prices remain a legitimate risk to the inflation outlook, and inflation is likely to be higher for longer. Apart from local factors, a new global normal for commodity prices suggests that inflation is likely to be higher than what we have been used to. The adverse impact of high inflation on corporate margins will be more pronounced given the stronger presence of the cost-push drivers of inflation and softening aggregate demand.
However, some deceleration in economic growth will soften demand-driven inflationary pressures, and the spending restraint in the Budget will be a constructive input in inflation management. The likely slippage in the fiscal deficit does not necessarily mean that domestic market borrowing will necessarily increase, as the government could again increase the foreign institutional investment limit in local currency government debt. In any case, the slippage will come more into focus later in the year.
Unseasonal rains late last year upset the inflation trajectory, but, in my humble view, the RBI is not behind the curve. It has aggressively raised rates, but hasn’t formally targeted inflation, even if that means killing economic growth. Additionally, the uncertainty around the revision of administered fuel prices messes up the inflation trajectory. While managing inflation, the RBI is also ensuring that higher rates do not suffocate the much-needed supply enhancement in the supply-constrained economy. Also, the investment upturn in the current cycle is much weaker than in 2004-08, real lending rates are well in positive territory, and the actual monetary tightening is much more aggressive than what the current level of repo rate at 6.5 per cent indicates.
Thus, critics of the RBI overlook that the current monetary tightening cycle is dramatically different from that in 2007-08, despite the repo rate being lower now. The magnitude of the pass-through to higher local fuel prices remains a key unknown for mapping the inflation trajectory. Still, the full impact of the 325 bps tightening so far has not been fully transmitted, and some moderation in growth is already appearing even if the industrial production data overstate it. Since crippling growth is not on the agenda to win the inflation battle, the RBI will likely adopt a go-slow approach here on, unless sharply higher global commodity prices mess up everything.
The author is a senior economist at CLSA, Singapore
The views expressed are personal
