The Indian economy has seen an inflationary recovery in 2010. In order to align interest rates with the expansionary phase of the economic cycle, the Reserve Bank of India (RBI) has hiked the repo rate by 150 basis points (bps) and reverse repo rate by 200 bps from the trough. Having reversed its accommodative stance, we believe that RBI should now pause for four main reasons.
First, the period of elevated inflation is coming to an end. Inflation as measured in year-on-year terms is still above the comfort zone, but inflation momentum as measured by the three-month seasonally adjusted annualized rate is down sharply from 17% in February to 2% in September. This is also reflected in the lower Wholesale Price Index inflation build-up at 3.9% in the first half of FY11, below the average increase of 5.6% over the last two years. Focusing just on the headline inflation misses out the changes in the underlying price trend.
Neither do we expect inflation persistence. Inflation expectations in India are driven primarily by food prices due to the high share of food in consumption expenditure.
Monetary policy surely cannot ignore a supply-side food shock because of its second-round effects. However, by the same token, continued policy tightening beyond a threshold can severely crimp demand. If indeed food inflation is structural—as seems likely in India—supply side reforms in agriculture have a greater role to play; monetary policy has already played its part. Moreover, in the near term, good summer harvests should lower food inflation from November, easing inflation expectations.
Second, there are early signs that industrial output growth is moderating. Investment activity, as measured by fixed capital formation, non-oil imports and capital goods production, has also moderated in the September quarter. There are expectations that the investment execution cycle will pick up in 2011, but interest rates need to remain supportive for this shift to take place, or else supply-side capacity constraints will persist, adding to inflation pressure.
Third, with call rates now hovering above 6%, interest rates are now close to the neutral setting. Monetary policy transmission to both deposit and lending rates are likely to continue even without any further policy action, due to tight domestic liquidity.
Fourth, interest rate differentials are not the only driver of capital inflows, but with global interest rates set to remain low for a prolonged period of time (the US Fed will probably not hike until 2013), it is likely to encourage capital inflows. Further, the rupee has appreciated by around 8% on a real effective exchange rate basis in the January-September period, which is the most after Malaysia in Asia ex-Japan. Capital controls are not an easy option for a high current account deficit economy such as India.
At some point, monetary policy settings may need to move from neutral to the tighter zone. For instance, when the output gap becomes positive or if surging commodity prices prevent inflation from moderating. Asset-price inflation will also play a more important role in the coming quarters. However, until the economy reaches that point, we believe that it is prudent to take stock of the policy actions delivered thus far. After all, monetary policy operates with long lags.
Sonal Varma is vice-president and India economist, Nomura Financial Advisory and Securities (India) Ltd
These are the author’s personal views.
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