There is always a difference in the interest rate outlook of bond traders and economists, but never has this been so wide as it is now, ahead of the mid-quarter monetary policy review of the Reserve Bank of India (RBI) to be unveiled this week. Eight out of 10 bond dealers are punting on a pause after 11 rate hikes between March 2010 and July 2011, taking the key policy rate from 3.25% to 8% to fight persistently high inflation in the world’s second fastest growing major economy. Most economists, however, expect the central bank to go ahead with yet another rate hike as inflation has not yet been tamed, inflation expectations continue to be high, and finally, economic growth is moderating but not collapsing.
First, let’s take a look at the arguments in favour of a pause.
The Index of Industrial Production (IIP) rose sharply by 8.8% in June year-on-year, higher than the revised 5.9% in May, but a volatile capital goods index is responsible for this. The consumer goods index continued to decline for the fourth month in a row.
The progressive decline in HSBC Purchasing Managers’ Index—52.6 in August, down from 53.6 in July and 55.3 in June—also reflects weak investor sentiment. Domestic passenger car sales have slumped and it is fairly clear that RBI’s tight money policy has started dampening demand even though its full impact has not yet played out. In five months between March and July, RBI has raised its policy rate by 150 basis points (bps). One basis point is one-hundredth of a percentage point.
A deteriorating global backdrop is also encouraging this camp to believe that RBI will press the pause button. The European sovereign debt crisis is still evolving and economic recovery for the US is not in sight as yet. The US Federal Reserve (Fed) is not as much worried about inflation as it was a month ago, but rising unemployment and decelerating growth are concerns. According to the Fed, the economy is growing modestly with pockets of weaknesses and high level of uncertainty among businesses. After announcing it would keep the short-term interest rate near-zero for two years, the Fed is now exploring unconventional steps to spur growth. The European Central Bank, too, warned last week that the euro zone economy will grow slower than it had expected and the medium-term outlook on inflation has moderated though it has not changed its policy stance. Overall, globally, risks to growth are more challenging than inflation and RBI could wait and watch before making its next move, bond traders say.
The arguments against pressing the pause button are equally strong. The major reason is high inflation. In July, the wholesale price-based inflation was 9.22% and the non-food, non-oil, or the so-called core inflation was 7.53%—both much above RBI’s comfort level. The consensus estimate for August inflation is around 9.6% and it will continue to remain 9% or above till November. RBI’s fiscal year-end inflation projection is 7%.
More than rising rates, a fall in commodity prices can help bring down inflation but the downward tend in global commodity prices has already been arrested; the prices are, in fact, rising. For instance, in Asian markets, the benchmark West Texas Intermediate crude price fell to around $82 sometime ago from $100, but now it is trading at around $88.5 per barrel. Similarly, Brent crude is trading at around $115 per barrel, down from $125, its recent high but higher than its price in early August. Between the last policy on 26 July and now, oil prices are down by about 2-3% but their rupee value has actually gone up as the local currency has lost about 6%. In the last week of July, one dollar fetched Rs 44.10; now the exchange rate is 46.50. India imports about 75% of its crude requirements. Even if the Fed restrains itself from going for yet another quantitive easing programme, its promise to keep cost of money at near-zero levels through 2013 is good enough to prop up commodity prices.
Indeed, the June quarter gross domestic product growth is 7.7%, lower than 7.8% in the preceding quarter, but there is no dramatic deceleration in growth.
On the supply side, growth eased for agriculture but manufacturing output and services sector activities were not dented. On the demand side, private and public consumption slowed, but investment growth bounced back.
More costly money has also not dented the credit appetite of Indian consumers. The industry’s credit offtake till early September has been 20.6% year-on-year, higher than RBI’s projection.
Overall, there is no reason for RBI to change its policy stance as there is a lot of steam left in economy and another 25 bps hike this week will be appropriate before signalling any pause, economists believe.
Two more sets of important data will be released early this week before RBI announces its mid-quarter review—factory output data for July and wholesale price inflation data for August. Most analysts expect IIP to fall and inflation to rise.
The daily cash deficit in the system is around Rs 35,000 crore, but will double in the second half of September when Indian firms pay advance tax.
It will be a close call for RBI on 16 September. I would like to believe it’s slightly tilted in favour of a rate hike, possibly the last before it presses the pause button as inflation continues to be a bigger problem in the Indian context than an economic slowdown. But one won’t be surprised if the Indian central bank takes a breather and allows the impact of four rate hikes in the past five months to be felt before going for another hike. A pause doesn’t mean the end of the tightening cycle, but RBI will have to communicate that message well to the market, if indeed it decides to do so.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Your comments are welcome at firstname.lastname@example.org