Mumbai: The key to the Reserve Bank of India (RBI) ending the rate hike cycle is for non-food manufacturing, or core, inflation to stabilize around 4-4.5%, says deputy governor Subir Gokaran.
Core inflation for May was at 7.3%.
RBI will press the pause button only when it sees “particularly the non-food manufacturing inflation starting to stabilize, which is what we saw in the second half of 2010,” Gokarn said in an interview at Bloomberg-UTV’s Banker’s Trust programme, to be telecast this week. “We need to keep an eye on that.”
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According to Gokarn, the number and overall magnitude of interest rate increases have a bearing on both economic activity and inflation expectations, and RBI expects that over time its set of hikes will lower inflation.
This will happen on account of two factors—one, economic activities will slow; and two, inflation expectations will moderate. This will then allow people to make their own planning and pricing decisions, based on lower inflation outlook. “It’s a process that takes time and we have to give it that time,” Gokarn said.
Unfolding RBI’s plan for a “soft landing”, Gokarn said the central bank is projecting that inflation will remain high till at least the middle of the fiscal year, but expects the cumulative impact of the rate actions to show in both slower growth and lower inflation numbers over the second half of 2011-12.
“Slower growth is something we accept as a price of managing inflation, but we don’t expect that slowdown to be dramatic... We expect that growth will move from 8.5% of last year to 8% this year but, along with that, inflation will come down from 9% to 6% by the end of the (fiscal) year assuming that no new shocks are to appear.”
Stating that a “neutral zone” of policy rate is a nice idea “but it’s difficult to quantify”, the deputy governor said “conceptually”, the interest rate is in a zone where it is possible for RBI to reverse the policy “fairly quickly” if the circumstances demand so.
In 2008, RBI’s policy rate was ruling at 9%, but within a few months it was brought down sharply when the world experienced an unprecedented credit crunch in the aftermath of the collapse of US investment bank Lehman Brothers. “If we are hit by a severe shock we do have the capacity to reverse,” Gokarn said.
After hiking rates six times between March and November 2010, RBI chose to hold its policy rate at 6.25% in its mid-quarter review of monetary policy in December, which many believe was not the right measure to adopt at that time. Gokarn defended the lack of action, saying the pause in hikes in December followed a moderation in non-food manufacturing inflation.
Manufacturing inflation, also known as core inflation, is essentially driven by demand and makes up the non-food basket of the wholesale price index. It spiked up to 8.5% in March after moderating at around 5.5% between June and October.
The pause was also in the backdrop of an unprecedented tightness in liquidity with banks borrowing at least Rs 1 trillion daily on an average from RBI to meet short-term cash requirements.
RBI has hiked its policy rate 10 times since March 2010. The 50 basis points (bps) hike in May was the biggest increase in the current cycle. One basis point is one-hundredth of a percentage point. Gokarn said one of the factors that forced RBI to go back to the 25 bps hike in last week’s mid-quarter review was a possibility of higher rates impacting business performance.
“Our readings of financial performance do not suggest that (the impact of higher rates) is broad-based yet, (but) it may become and that’s a possibility that we have accommodated because one of the factors against a 50 (bps hike) this time is that the slowdown we anticipated may gain some momentum... There is a consideration of the factor,” he said in reply to a question on whether rate hikes are hurting companies.
Average inflation in the previous fiscal year was 9.57%, the highest since 1995, and much higher than RBI’s projection. RBI’s original projection for inflation was 5.5%; after two revisions, this was raised to 8%.
Analysts are sceptical about RBI’s 9% inflation projection till September as it was 9.06% in May and a likely oil price hike and the food security Bill that promises subsidized food to 68% of India’s population will put pressure on inflation. Gokarn said 9% inflation till September is not a target but a projection; “it’s based on certain assumptions and if assumptions go wrong, projections will go wrong,” he said.
“We have pointed to some factors that may cause inflation to increase but there are also factors that may cause inflation to decrease—like commodity prices may soften, economic activity may start to moderate, which will have an impact on pricing power.”
Admitting that the central bank was in danger of losing its credibility after missing its inflation projections last year, Gokarn said the 50 bps rate hike in May was prompted by RBI’s desire to demonstrate that it has not “diluted” its “commitment to inflation control”.
“We felt that we had to reclaim the position that we had not given up on inflation, that it was very much a priority, and if people, markets, investors intermediaries were not convinced, we needed to take stronger action.”
Freeing savings rate
During the interview, Gokarn dropped a hint that RBI may not push hard for freeing the savings bank rate.
In May, RBI released a discussion paper on the pros and cons of deregulating the savings bank rate and is now gathering feedback on the paper.
“We toyed with the idea of putting up a working group but we realized that the views on either side were so firm that the working group would not end up in a consensus. So we said let’s put out a discussion paper with the pros and cons and get feedback, which we are getting now.”
His personal view is that “there is merit in it (the savings bank rate) being deregulated because it is consistent with the overall financial reform strategy”, but RBI has to “take into account the fact that a lot of people see this as a safe and reliable source of monthly income and that’s a viewpoint that has come out strongly from a variety of stakeholders”.
“We can’t just say (that) we are not going to address your concerns. So, I would presume that the outcome would be either status quo, which is always a possibility, or some sort of a middle ground where these stakeholders’ interests are given some considerations.”