The Reserve Bank of India’s (RBI) decision to hike the repo rate by 50 basis points to 8% has come as a surprise. While global uncertainties have risen, the RBI remains confident that moderation of domestic growth is not yet broad-based, even as the rise in inflation is becoming more so. Inflation expectations are becoming entrenched due to persistently high food prices, while rising wages are another worry. In this backdrop, the RBI remains firmly on the tightening path that started 16 months ago. The key question, going forward, is whether more tightening is necessary.
Interest rates in India are no longer low. Simple estimates of real rates, when adjusted for inflation, suggest that real rates are negative. However, the reality is different. Even though the current repo rate of 8% is 100 basis points (bps) below the 2008 peak of 9%, State Bank of India’s prime lending rate, a good proxy for systemic lending rates, is at 14.25%, which is 50 bps above its 2008 high. The bite of the RBI’s rate hikes has been significantly more effective during this tightening cycle due to the significantly tight banking system liquidity.
Demand has also begun to moderate. Leading indicators suggest that the economy is already slowing down, but this is not yet broad-based. Interest rate sensitive sectors are slowing sharply; non-interest rate sensitive consumption demand is only starting to moderate, while external demand-driven segments are still performing well.
However, a global slowdown could transform India’s soft landing into a hard landing. The steep fall in the export new orders component of India’s manufacturing PMI (Purchasing Managers Index) suggests that the boost from the external sector may soon start to dissipate. Along with an already moderating domestic demand, this could accelerate the slowdown. Policymakers have to be alert to this non-negligible risk.
Despite signs of growth flagging, inflation has remained stubbornly high. To an extent, this is due to the hike in minimum support prices for food and rising rural wages, which have created an expectations spiral that is becoming difficult to break. Tight monetary policy has become necessary to counter expansionary fiscal policy.
More importantly, repeated supply-side shocks and higher-than-expected global commodity prices appear to be the main reasons why the RBI has consistently been missing its inflation target. We do not doubt that inflation will remain elevated in the near term. However, the RBI has already reacted aggressively to this risk. The recent fall in global commodity prices should partly ease input cost pressures, while subdued demand should keep core inflation under check. The flat month-on-month reading of June core inflation is evidence that this is occurring.
The main upside risk to inflation and the rate outlook is a potential rebound in global commodity prices. However, given the current global uncertainties, stable global commodity prices, signs the economy is already slowing down and lags in policy transmission, we believe conditions are falling in place for a prolonged pause.
(Sonal Varma, India Economist, Nomura Financial Advisory and Securities (India) Pvt. Ltd)