The RBI today continued the tightening cycle and thankfully took a more decisive step with a 50 basis point hike, beating market expectations. The case for an aggressive move was strong, but the heightened uncertainty about the global economy and exaggerated concerns about the moderation in the domestic economy had actually raised pressures for a pause, mostly from groups seeking to protect their own short-term interests, rather than internalizing what is ultimately the best for the economy as a whole.
Had the RBI today not tightened to its own tune, including by completely abstaining, it would have accelerated the upward drift in inflation expectations and risked bringing about even more difficult-to-control inflation dynamics. This would ultimately have proven more growth destructive than a proactive policy approach, which recognizes the need for a slowdown in the short term to ease inflation pressures and sustain growth over the medium term.
Now, it is true that dark clouds are hanging over the global economy, but we think that the sun will eventually shine through, with the global economy expected to pick up pace during the second half of the year as inventories have been slimmed down sufficiently and Japanese factories are back to full speed. Of course, there is a risk that the global soft patch could prove softer still, with the ongoing US and European sovereign debt sagas offering their own layer of risk. That being said, the domestic orientation of India’s economy allows RBI to wait-and-see for longer than central banks in more export-driven Asian economies.
Given the domestic orientation, India’s growth dynamics have a life of their own. Yes, there has been a slowdown in recent months, but growth in India is moderating and not collapsing as evident from the solid momentum signalled by the latest credit and HSBC PMI (Purchasing Managers Index) readings, for example. So, no need to panic on the growth front. Moreover, the slowdown is only to be expected in light of the monetary tightening undertaken so far. Importantly, the uncertainty created by the elevated level of inflation is also dampening growth, especially investment, and the tight capacity in the economy is imposing a natural speed limit. The latter two points underscore the importance of today’s hike and the need for continued policy tightening.
Moreover, inflation is not yet coming off its highs, despite the moderation in growth, and is set to rise further as adjustments in diesel and other controlled fuel prices kick in. In addition, with capacity already tight and domestic demand still solid, underlying core inflation pressures will remain firmly in place.
With this backdrop, the RBI rightly considers inflation the dominant policy concern. It is also important here to understand that monetary policy currently, at best, is in neutral gear. But, it needs to move into contractionary mode to bring about the required easing in demand-led inflation pressures. This is why we expect the repo rate will move above neutral this year and reach at least 8.25%.
(Leif Eskesen Chief Economist for India & ASEAN HSBC Global Research, Singapore)