There is a considerable amount of market focus on next week’s Reserve Bank of India (RBI) policy meeting, with opinions divided on whether the Indian central bank will continue its policy of calibrated tightening, or do more in the face of inflation surprising significantly on the upside. There are overwhelming reasons why RBI needs to show firm resolve, and raise policy rates by 50 basis points (bps). One basis point is one-hundredth of a percentage point.
Negative real rates, loose fiscal policy, growth still at potential, the need to contain rapidly rising inflationary expectations and the second-round effects of food and energy shocks—all argue for decisive action by RBI.
There is little doubt that high and persistent inflation is India’s chief macro risk. The recent increase in inflation is worrying for two reasons—it has increasingly become broad-based—with non-food manufacturing inflation (RBI’s preferred measure of core inflation) rising to more than 7%, suggesting that food and fuel inflation has filtered through to core inflation. Second, the recent upward revisions have changed the level and trajectory—it is extremely difficult for inflation to fall below 8% over the summer, and there are clear risks to the upside as oil price increases pass through.
In this context, RBI’s action needs to be bolder than normal due to several reasons.
First, real rates remain in negative territory and have actually fallen recently. If we measure inflation expectations for fiscal 2012 as consensus forecasts for wholesale price-based inflation (WPI), then it has risen by 150 bps since November. However, the repo rate has risen by only 50 bps since then. Therefore, real rates may have fallen by 100 bps since November.
Even on a longer time horizon, real rates currently are lower than the historical average. With consensus forecasts set to rise after the March inflation print, real rates may fall further. Thus, to the argument that RBI has already increased rates significantly, the response is that inflation, and expectations of it, has outpaced the policy action.
Second, growth remains at potential in 2012, and we would need to see growth fall below potential to curb pressures on core inflation. Indeed, our Goldman Sachs India Financial Conditions Index shows that more tightening is required to reduce nominal gross domestic product (GDP) growth to levels which can put downward pressure on prices.
Third, fiscal policy will most likely be looser than what was proposed in the budget due to the subsidy burden of higher oil and fertilizer prices. Therefore, the burden of tightening will have to fall disproportionately on monetary policy.
Fourth, RBI would need to contain the second-round effects of food and energy shocks. The direct impact of food and fuel has been a key driver of inflation. More recently, second-round effects on core inflation have become visible as producers have passed on price increases. Therefore, RBI may need to tighten more than otherwise, so that it doesn’t accommodate second-round effects.
Inflation expectations have ratcheted up sharply over the course of the last fiscal year, and particularly in the last few months. There is a real threat that they become unhinged, requiring a much higher cost in terms of growth, in bringing them down.
The policy of RBI thus far has been to keep rate changes expected and well-communicated. However, to tackle a sharp rise in inflation expectations, unanticipated monetary policy would work better. Therefore, RBI needs to send a clear and unambiguous message through its actions that it wants to lower inflation expectations.
Further, given the lags in monetary policy, it makes little sense to raise interest rates in smaller increments of 25 bps, when the problem is clear and present, and the need of the hour is to get ahead of expectations.
The doves would say that higher rates will slow down growth dramatically. Indeed, some amount of deceleration is required to put downward pressure on core prices. However, real borrowing costs are still not at levels that can cause a more pronounced slowdown. Our financial conditions index shows that there can be further tightening without a significant slowdown in growth.
With core and headline inflation surprising significantly on the upside, the time for a calibrated approach is over. RBI has to show firm resolve as the principal fighter of inflation, and not succumb to the doves. Else, it faces a loss of credibility, but worse still, risks continued erosion in the purchasing power of India’s poorest.
Tushar Poddar is chief economist, Goldman Sachs India.
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