The Reserve Bank of India (RBI) has its task cut out to contain inflationary pressures in the economy. The Indian central bank set out on a non-disruptive normalization of monetary policy from March 2010 and the incremental moves were calibrated to only 25 basis points (bps) at each step. RBI is facing criticism for such “baby steps” from some quarters and is also perceived to be seen behind the curve.
However, there is possibly little that RBI could have done differently in an atmosphere that was fraught with risks from the global arena and domestic growth was just at the cusp of a recovery and yet to become broad-based. On the back of monetary tightening, wholesale price-based inflation or WPI did behave well and also exhibited a moderating trend till around November, when it was at 8.1%. But renewed price pressures were seen from December, with the new drivers of inflation being fuel and non-fuel international commodity prices and demand-supply imbalances domestically in some food items, especially fruits and vegetables.
Inflation kept consistently surprising on the higher side and the provisional figures got revised upward by 100-125 bps. March 2011 inflation was recorded close to 9%; the revised figure could possibly be closer to 10%. One should also remember that a significant part of global fuel price inflation is yet to be passed through to domestic consumers.
As per current understanding, inflation is likely to rule at a high level of 8-8.5% for a significant period in fiscal 2012, with its trajectory remaining significantly unpredictable and volatile. A large proportion of items within the WPI basket also have not been updated for quite some time now, leading to risks of awkward jumps. And worst still, the monetary policy might, in this round of price rises, not prove effective enough. This is because a large part of the inflation is based on supply-side factors and will take time to correct.
Global factors such as high prices of commodities, both hard and soft, are also contributing largely to this. While metal prices have been hitting higher levels globally on account of excess international liquidity consequent to QE2 (second quantitative easing) in the US, prices of commodities such as cotton are up on supply worries. As a fallout of this, domestic cotton prices have been rising significantly (up nearly 100% over last year), despite a better domestic crop.
Higher interest rates notwithstanding, core inflation had perked up as demand failed to relent on account of continuing fiscal accommodations in the form of higher minimum support price for crops, inflation-linked wage adjustments for the government’s rural employment generation scheme as also for public sector workers. Examples of pricing power of domestic manufacturers are apparent in the rise in prices of items such as textiles and cars, leading to a perk-up in core inflation.
RBI will have to continue to tighten, but, in my opinion, should do it in a calibrated manner of 25 bps rate hike on each occasion. Growth dynamics are getting a bit hazy and investment demand is reported to be falling. At this juncture, RBI is unlikely to risk growth. Despite continuing high inflation expectations in the economy, RBI is also likely to pause at a level much lower than the previous tightening cycle when the repo rate touched 9% as did banks’ cash reserve ratio. This is because there are no apparent signs of overheating in the economy like in the previous cycle; real estate and the equity markets are not showing any bubbles.
My bet would be a maximum of 100 bps increase in the repo rate in phases, followed by a pause. This will provide scope to RBI to assess the impact of previous monetary tightening, the effect of which is felt with a lag of 12-18 months. RBI’s estimate of growth in India’s gross domestic product in fiscal 2012 could be 8% and an inflation projection of 5.5% by 31 March next year. Associated with this would be an M3 (money supply) growth target of 17%, deposit growth of 17% and credit growth of around 20%. RBI should continue to remain happy with tight liquidity conditions sustaining to ensure a more effective transmission of monetary policy actions.
Indranil Pan is chief economist, Kotak Mahindra Bank.