To take a side on the debate over a repo rate cut in the 30 October monetary policy, it is necessary to take a step back and provide a perspective to the recent monetary policy stance of the Reserve Bank of India (RBI). While the memories of 13 rate hikes are still vivid in our minds, we must not forget that the last rate hike was done exactly a year ago. Since then, the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR) have been reduced by 150 and 100 basis points (bps), respectively, open market operations (OMOs) of more than Rs.2.1 trillion have been conducted, and RBI has cut the policy rate by 50 bps. (One bps equals one-hundredth of a percentage point.) So it’s fair to say that RBI has responded to slowing growth concerns by gradually easing the monetary policy.
In the October policy, the question facing RBI is whether there is a need to accelerate the process of this monetary easing. In the last few policy statements, RBI has repeatedly mentioned two preconditions for it to be more comfortable towards monetary easing—lower inflation and steps to reduce the fiscal deficit. It is now time to make a qualitative judgment on them.
On inflation, the good news is that headline WPI (that based on the wholesale price index), which was running at an average of around 9.5% in 2011, dropped by 200 bps in the first three quarters of 2012. However, both CPI and WPI are still running way above RBI’s comfort level of 4-6%. In fact, we are worried about a sustained shift in average inflation—between 1995 and 2002, average WPI was 5%, which increased to 6% between 2003 and 2008, and has been hovering at 7.2% since 2009.
Rising inflation is making household inflationary expectations sticky. Even after the 200 bps drop in average WPI inflation in 2012, households’ one-year ahead inflation expectation is almost unchanged at 12.8%.
The near-term inflation momentum will also be closely watched. The last two headline WPI prints have been higher than market expectations and the month-over-month increase for September (1.08%) has been higher than for the same month last year (0.84%). Surely, the diesel price hike can be partly blamed, but even if one looks at only manufactured inflation, the month-on-month increase (0.54%) was higher than last year (0.43%). Sugar contributed to this increase but for all consumer goods (food products, transport equipments, textiles, paper, wood, leather, rubber and plastic products) the month-on-month increase was higher than for the same month last year. In that sense, it is difficult to say that demand-side price pressures have been brought under control to justify accelerated monetary easing.
Looking forward, we can hope that food inflation will be kept under check with a good winter crop and the muted response of global commodity prices to QE3 (the third quantitative easing by the US) should help. Even the modest currency appreciation should be positive but the lagged effect of fuel price increases is likely to pass through the system and we will not be surprised to see an above 8% WPI print soon. In our base case scenario, inflation will slow down in Q4FY13 but is unlikely to come anywhere close to RBI’s comfort level. Premature easing could spur inflation again, affecting RBI’s credibility.
Some politically difficult measures taken by the government to reduce the fiscal deficit are definitely on the right track. However, the impact of these on the FY13 fiscal deficit could be minimal and one-off items such as the 2G auction and divestments are likely to determine the final deficit number. Similarly, we are waiting for more clarity on implementation issues surrounding the other supply-side reforms. In our view, these uncertainties and the difficult inflation situation push the rate cut possibility a little bit down the road. A CRR cut to improve liquidity could be on the cards to keep positive sentiment afloat. After all, the CRR cut had a better transmission in September and it is to some extent a substitute of likely OMOs.
But a repo rate cut is more likely to be a Christmas gift than a Diwali one!
(This is the last in a series of five articles ahead of the Reserve Bank of India’s second-quarter monetary policy review on 30 October.)