The Indian central bank is fast acquiring a reputation for being unpredictable. After pleasantly surprising markets with a larger-than-expected 50 basis points (bps) rate cut in April, the Reserve Bank of India (RBI) has shocked markets by not cutting rates in the June mid-quarter review.
One basis point is one-hundredth of a percentage point.
While yours truly also expected RBI to yield to pressure from the markets and cut rates, I have to say that Monday’s decision is the more sensible one.
The key feature of the mid-quarter statement is that it is consistent with the April annual policy statement. Recall that in April RBI had pointed to a limited space to ease monetary policy due to upside risks to inflation. Further, the overhang of subsidies and fiscal deficit circumscribed RBI actions.
Since the April policy, wholesale price inflation has trended higher even as core inflation has been well-behaved. More importantly, the government has refrained from tackling the pressing problems of fuel and fertilizer subsidies.
While domestic markets have taken comfort from the fall in global crude prices, the reality is that the oil marketing companies’ under-recoveries on account of selling fuel below cost are set to increase this year from last year as a weaker rupee has more than offset the savings from lower crude oil prices.
To compound worries about government finances and inflation, procurement prices for summer crops have been hiked by an average 23.1%. The last time procurement prices went up by more than 20%, it triggered double-digit inflation in farm products for two years in a row.
Thus, in the cold light of the day, the constraints hemming in monetary policy have not eased. It is useful to remember that India’s case is different from that of advanced economies that are facing a slowdown. India is flirting with stagflation and needs a dose of supply side reforms to improve medium-term growth potential.
In the short run, meaningful reduction in the fiscal deficit would remove macro risks and leave the field clear for RBI to ease policy. However, the political realities are such that the chances of structural reforms and fiscal consolidation are uncertain.
Does this mean that RBI will not come to the aid of the economy even if growth undershoots 6%? The policy statement is clear that inflation outlook will determine future course of policy action.
Thus the 50 bps rate cut in April was not the start of an aggressive rate-cutting cycle but the maximum that RBI could have done in the current context. Unless headline inflation comes off to below 7% and the government tackles the subsidy issue, RBI may decide to sacrifice growth. Looking at the likely inflation trajectory, WPI inflation may not fall below 7% till the March quarter of 2012-13 fiscal year should the government bite the bullet and hike fuel and fertilizer prices in the next few months.
Thus, I expect RBI to wait till the second half of the current fiscal year before cutting rates again; cumulatively, I expect RBI to cut the repo rate by 50 bps and cash reserve ratio by 75 bps in the second half of the fiscal year. Needless to add, should global financial conditions worsen due to developments in the euro zone, RBI will react swiftly. However, this still remains a tail event and the base case is of the central bank waiting for the government to take some tough decisions.
A. Prasanna is chief economist, ICICI Securities Primary Dealership Ltd.
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