The economy has emerged out of a shallow slowdown and the business cycle is entering the expansion phase. Inflation, meanwhile, is at elevated levels as the impact of high agri-commodity and fuel prices has been aggravated by rising prices of manufactured goods. The obvious reaction of any central bank would be to tighten policy at every given opportunity and quickly reset rates as well as liquidity conditions to normal or equilibrium levels.
However, this is easier said than done. A survey of global central banks would indicate that only a handful of them—including the Reserve Bank of India (RBI)—have embarked on the journey of policy normalization. Even among this handful, only the Reserve Bank of Australia has actually tightened policy, the rest merely taking baby-steps in their exit strategy. The majority of global central banks, including the US Federal Reserve, are busy fighting last year’s battles, as their economies are still not out of the woods and are struggling with mass unemployment. Developed economy central banks also have to reckon with skewed incentives in favour of low rates—the financial sector is banking on low rates and a steep curve to restore profitability, while governments bet on strong growth and some inflation to soften the burden of sovereign debt.
While this means that the Fed and other Western central banks would want to be doubly sure before they start exiting from stimulus, Asian and other emerging economy central banks would be leading the way when it comes to monetary tightening. Therein lies the problem for RBI, given the implications for the capital account and the rupee.
It has hardly shown its hand in the currency markets during the recent rupee rise. Such forbearance is likely to be tested in the coming months as the rupee has appreciated significantly in real terms and capital flows may pick up as markets re-rate growth prospects.
This is not a new problem for RBI, but the combination of some tightening via currency already in train and the possibility of capital flows triggered by higher rate differential with US may figure in RBI’s policy calculus. The temptation would be to deliver only marginal tightening, say a 25 basis points (bps) hike in repo and reverse repo rates. It may also take comfort from lower-than-expected March inflation, but this would be a misguided approach, in my opinion.
For one, tightening via currency appears to be a poor choice as in India interest rates and bank credit play a larger role in dictating monetary conditions. Secondly, capital flows seem to be attracted to India more because of higher growth rather than higher rates. More pertinent, growth outlook has improved and inflation outlook hasn’t changed materially since RBI’s last rate action, if one abstracts from the recent data on output and prices. The surge in capital goods output in the last three Index of Industrial Production readings, jump in non-oil imports and the step-up in credit off-take suggest pent-up capex demand. Anecdotal reports of capacity constraints in finished goods industries also buttress this view.
Indian exports may enjoy a sweet spot for the next few quarters, providing another leg-up to domestic growth. On the other hand, the same capacity constraints that may drive investment demand may also embolden firms to pass on higher costs to consumers. These cost pressures may arise from elevated commodity prices and higher wage costs as higher inflation expectations get priced in.
More worrying, the anticipated relief on agriculture prices on account of a normal monsoon may not materialize fully, as the government is likely to step in and cushion farmers from any large adverse price shocks. Note that over the last six years, government policy has been geared towards tilting the terms of trade in favour of the agriculture sector. To sum up, inflation risks arise from structural as well as cyclical factors. With overnight rates at 3.5% and equilibrium levels of rates around 6%, RBI has quite a lot of heavy lifting to do in 2010-2011 before it can rest easy.
I expect RBI to hike repo and reverse repo rates by 50 bps each in next week’s policy. While it can always hike by 25 bps next week and choose to hike again before the July policy, that may precipitate needless volatility in financial markets. By hiking these rates by 50 bps, RBI can afford to take a pause till July even as the economy absorbs the impact of both monetary and fiscal tightening. By July, there is also likely to be greater clarity on the path of US rates, on the back of three months of jobs data.
In order to retain flexibility for any inter-meeting action, RBI should refrain from hiking the cash reserve ratio (CRR) next week. With the banking system likely to witness large outflows in the coming weeks after the completion of auctions for third-generation and broadband wireless access spectrum, hiking CRR in the April policy could prove counterproductive. The upcoming policy should be all about taking an important step on the path of normalizing policy rates.
This is the second 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.
Prasanna A is Head-research at ICICI Securities Primary Dealership Ltd
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To read the first column in this series, go to www.livemint.com/policyprescription.htm