The end has come. After 13 interest rate rises, through which the Reserve Bank of India (RBI) has lifted the repo rate from 4.75% to 8.5%, Tuesday’s 25 basis points hike is likely to be the last in the tightening cycle. In my opinion, the first rate cut will be delivered in the April-June quarter of next year.
For the first time in a long while, RBI’s second-quarter review of monetary policy suggested the downside risks to economic growth were sufficiently large to be taken account of explicitly. This is despite the fact that inflation remains way above RBI’s comfort zone and price expectations are dangerously elevated. Clearly, RBI is banking on the prospect of weaker growth bringing down the underlying inflationary pressures.
We agree with the central bank that inflation will start to fall in a meaningful fashion with the release of the December wholesale price inflation numbers, although softer domestic demand will probably have little to do with it. Much of the movement in wholesale price inflation is driven by international commodity prices, which have started to turn down on a year-on-year basis. This factor alone should be enough to cut the headline inflation rate by three percentage points.
So has RBI tightened too much already? This is a very difficult question and one to which the answer may only be clear in a year or two. For what it is worth, however, I believe the bank’s tough action was warranted. While rates were cut too much during the global financial crisis (easy to say in hindsight) and hiked too slowly during the initial stage of the tightening process, my view for a long time now has been that an extended period of sub-par gross domestic product growth is exactly what is required to ease bottlenecks and bring down inflation expectations.
It is certainly true to say that the monetary squeeze will do little to bolster the supply side of the economy, but then again, nor would a wage-price spiral that risks getting out of control. Quite rightly, RBI’s priority has been to try and tackle inflation, and I think the lagged impact of all the rate rises has a good chance of doing that.
RBI is also correct in implying that the government has not exactly pulled its weight in helping control the underlying inflationary pressures in recent years. Ideally, one would have liked to have seen widespread infrastructure improvements as well as a range of measures designed to boost agricultural productivity. Unfortunately, these have been more notable by their absence.
From a market perspective, while I think it is still too early to buy either Indian equities or sovereign bonds in size, that period is fast approaching. During the March quarter of 2012, most of the growth disappointment should be priced in and inflation is likely to be on the way down. With interest rate cuts becoming imminent as a result, it will be time to pull the trigger. Greater foreign buying might even lift the sagging rupee.
Robert Prior-Wandesforde is head of India and South-East Asia economics, Credit Suisse.
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