Unanimity on policy matters is rare. However, for the Reserve Bank of India’s (RBI) upcoming policy meeting there is already a consensus emerging that inflation will trump growth as RBI’s primary concern and that some form of policy tightening is essential. The only divide is between those who believe that RBI should hike policy rates by a calibrated 25 basis points (bps) versus a more aggressive 50 bps.
Sonal Varma: Vice-president and India economist, Nomura Financial Advisory and Securities (India) Pvt. Ltd
In our view, normalizing policy rates quicker is a more prudent approach.
First, private demand is ready to take off. Consumer sectors have benefited from the government’s fiscal stimulus and strong employment prospects indicate resilient consumption demand. Meanwhile, capacity utilization rates are fast ratcheting up in line with the acceleration in industrial production. With spare capacity shrinking and demand getting stronger, the next step should be increased investment. This is already starting: Non-oil imports rose 40% during the first two months of 2010, and capital goods output growth rose 50% over the same period. We think the risk is that this acceleration is being underestimated. While banks are still being cautious regarding the strength of the credit off-take, the order books of construction companies are rising. As these orders translate into execution, capacity constraints will become even more telling.
Second, stronger core inflation indicates that inflation will persist at higher levels for longer. Non-food manufactured inflation has risen from -0.3% last November to 4.7% year-on-year in March. From oil to metals, coal, iron ore and other raw materials, input cost pressures have skyrocketed. High input costs and rising aggregate demand is the perfect recipe for higher output prices, or else firms will face margin pressures. RBI’s own analysis suggests that higher oil and metal prices transmit to other commodities within a quarter, while the full transmission of higher food prices takes almost a year.
Third, current inflation rates are suppressed. At current oil prices, losses at oil marketing companies are running at more than Rs80,000 crore, making another fuel price hike inevitable. Even excluding oil, higher prices of a number of minerals and metals are still not reflected in the current wholesale price index, making a one-shot adjustment very likely. Therefore, our base view is that wholesale price-based inflation will remain above 9% at least until July and above 8% till October—essentially remaining above the tolerable limits for an extended period.
Fourth, the risk of economic overheating is real. Barely a year into the crisis, apart from a double-digit inflation rate, India’s current account deficit has widened to more than 3% of gross domestic product (GDP), the highest in many years, as consumption-related imports have held up fairly well. Given the domestic supply side constraints, it is no surprise that higher demand is leaking out in the form of rising import growth.
Fifth, from a medium-term perspective, it has to be kept in mind that India’s economy is in a take-off mode and most economies during their take-off had to grapple with higher inflation initially as investments always add to demand immediately, while they lead to higher supply only with a lag. The trick for RBI is to not let inflation derail long-term growth prospects, even if it means sacrificing some near-term growth.
Sixth, as far as tightening liquidity is concerned, fiscal policy has hijacked monetary policy. To manage both higher credit growth and the government’s borrowing programme, RBI will have to tolerate higher money supply growth, with the side effect of higher inflation. Tightening liquidity too sharply would derail bond auctions, thus implying that it will be difficult for RBI to shift the operating corridor from the reverse repo rate to the repo rate. Therefore, raising overnight rates from their current crisis levels calls for more aggressive hikes in the reverse repo rate.
All said, we believe that RBI should front-load its rate hikes, given the time lags in policy transmission and the main economic uncertainty shifting from downside growth risks to upside inflation risks. We pencil in a 50 bps rate hike in the second quarter of the year and another 50 bps in the third quarter. If caution gets the better of RBI and it delivers a 25 bps repo and reverse repo rate hike on 20 April, then we judge that another inter-meeting hike will be on the cards. As far as policy normalization is concerned, we believe it is time to step up and take the bull by its horns.
This is the third in a series of columns by four top economists on their expectations from the Reserve Bank of India’s annual monetary policy announcement scheduled for 20 April that comes against the backdrop of rising inflation and a resurgent economy.
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