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Business News/ Opinion / RBI should hold interest rates, for now
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RBI should hold interest rates, for now

India is not out of the forest of inflation. There is no case for rate reduction

Illustration: Jayachandran/Mint Premium
Illustration: Jayachandran/Mint

Raghuram Rajan took the markets by surprise on 20 September 2013 when he increased interest rates to fight persistently high inflation. He followed up with two more rate hikes in the months that followed.

The Reserve Bank of India (RBI) governor will present his new monetary policy at a time when inflation has eased considerably. Consumer price inflation is at its lowest level in 30 months. Wholesale price inflation is also within the comfort zone. Core inflation seems benign as companies have not yet regained pricing power.

Yet, it is too early for Rajan let his guard down.

In June, RBI had issued a dovish forward guidance that “It remains committed to keeping the economy on a disinflationary course, taking CPI inflation to 8% by January 2015 and 6% by January 2016. If the economy stays on course, further policy tightening will not be warranted. On the other hand, if disinflation, adjusting for base effects, is faster than currently anticipated, it will provide headroom for an easing of the policy stance".

The trouble is the sensitivity of the Indian economy to sudden price shocks that is capable of upsetting such assumptions within no time. Currently, two problems loom on the horizon that can potentially alter the central bank’s “glide path" to a low inflation regime.

An erratic monsoon leading to a decline in agricultural output in the months ahead and the still high risk to oil prices due to the fluid political conditions in the Middle East and additional flashpoints elsewhere in Eurasia. When these are viewed with the easing trend in consumer price index (CPI) and wholesale price index (WPI) inflation, the case for caution by RBI and holding interest rates is stronger.

Consider the risk from poor agricultural output due to an adverse monsoon, which remains the major cause for concern.

After an initial deficit, the monsoon has gathered strength in the past one week but in key agricultural regions, the position remains alarming. In northwestern India, Punjab has seen a cumulative shortfall of 60% and Haryana 54% shortfall (both until 3 August). The two states are important for rice production. But even more worryingly, in Maharashtra—a state important for pulses, another commodity subject to a quick inflationary spike—the Marathwada region has seen a shortfall of 61% and Vidarbha a shortfall of 20% (again until 3 August).

So the two commodities that will see price pressure, if rainfall does not improve, are rice and pulses. Rice may be manageable as the Union government has abundant stores of it but pulses will cause a headache.

The danger from food inflation turning into generalized inflation should not be underplayed. The two key drivers of inflationary expectations in the three month and one year ahead periods are food and fuel price hikes. Studies by RBI show that a 100 basis point shock to food prices affects one-year ahead expectations by as much as 50 basis points, persisting for eight quarters.

Something similar happened in 2009, the last year when India experienced a drought. In that year, a 27% shortfall in rain in August led to a price spike in pulses. It is for this reason that coverage in rainfall dependent states where pulses and coarse cereals predominate—Rajasthan, Maharashtra, Karnataka and Madhya Pradesh—is important this month. So far, rainfall in these states has remained deficient cumulatively and has improved only the last couple of days.

In these circumstances, it will be risky for RBI to go in for a reduction in the policy rates. It will be better if it holds interest rates for the moment.

Will holding interest rates affect the process of recovery of growth? Maybe not. At the moment, banks are reluctant to lend money to medium and large industries for the fear of adding to their non-performing assets.

In the June quarter, agricultural and personal loans accounted for all the non-food credit growth by banks. A reduction in the policy rate will not dramatically improve credit disbursement to industry and its growth, often projected as a reason for India’s falling growth rate.

Are policymakers being complacent about dangers of inflation in India? Tell us at views@livemint.com

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Published: 04 Aug 2014, 05:42 PM IST
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