The Reserve Bank of India’s (RBI’s) decision to hike policy rates by 50 basis points (bps), instead of its tried and tested calibrated approach, suggests that inflation worries have reached a crescendo and baby steps are no longer enough.
This aggressive approach is not surprising. Unlike in December, when the inflation spurt was led by high food prices, the surge this time is driven by rising core, or demand-side, inflation. Worryingly, this increase looks like it will persist.
Input cost pressures remain high and are hurting margins across sectors. Reasonably firm demand means that these costs are likely to be passed on to consumers, further aggravating core inflation. Moreover, an impending fuel price hike and double-digit inflation expectations risk adding to underlying inflationary pressures.
With price pressures clearly on the upside, RBI’s Wholesale Price Index (WPI) inflation projection of 6% with an upside bias by March 2012 appears too low.
Meanwhile, concerns on growth have emanated due to the weakness in industrial production and a sluggish investment cycle. Rising input costs, higher interest rates and slow government decision-making have all combined to delay capital expansion plans.
Consumption demand remains unhindered due to continued government spending, rising incomes and improved consumer confidence, which have negated the ill effects of high inflation. Booming exports are a positive and services sectors such as financial services, wholesale and retail trading, hotels, transport and communication remain buoyant. Therefore, while there are headwinds to growth, RBI’s real GDP (gross domestic product) growth projection of around 8% in fiscal 2012 appears realistic.
The persistence of high inflation, despite rate hikes and tight liquidity, suggests that fiscal policy may be undermining monetary policy both by putting income in the hands of rural consumers and by not sufficiently boosting supply. Hence, it is not surprising that rate hikes are not dampening consumption and hurting investment, thus further widening the demand-supply gap and fuelling inflation.
Tackling inflation requires putting a lid on consumption and boosting investment. Monetary policy will remain tight but fiscal policy has a greater role to play, both by reducing the fiscal stimulus and by easing supply-side constraints.
The current environment of high growth and high inflation is not sustainable. Slower growth now is a preferred alternative to boom-bust cycles caused by high inflation, which can result in a substantial loss of economic output. However, given the lags in policy transmission, the near-term adjustment path will be difficult. We continue to expect the wholesale price inflation to accelerate over the next two quarters towards double digits.
Meanwhile, risks to the growth outlook have risen. RBI’s rate actions could mean a few years of around or below trend growth rate as a necessary evil to contain inflation. Going forward, rising core inflation calls for further tightening in monetary policy.
Having delivered an aggressive hike in May, RBI can now continue to move in 25 bps steps. In total, an additional 50 bps worth of rate hikes is likely in 2011.
Sonal Varma is India economist, Nomura Financial Advisory and Securities (India) Pvt. Ltd.
Respond to this column at firstname.lastname@example.org