The Reserve Bank of India’s (RBI) policy bias appears to be shifting from easing to neutral with growing inflation concerns. The question is how long RBI should wait before it withdraws its expansionary measures. The answer depends on three factors: the government’s borrowing programme, the demand for credit and the inflation-growth trajectory.
Government borrowings are key. As long as the supply from government is large, RBI will stay committed to maintaining excess liquidity so that yields do not spike suddenly and crowd out private investment. With this in mind, the government and RBI have front-loaded a large part of the borrowing programme, with much of the borrowing likely to be completed by the end of 2009. RBI will also have to maintain a benign interest rate environment until credit growth recovers.
More importantly, the growth/inflation dynamic should gradually shift in favour of inflation as the year progresses. There are signs that economic activity is picking up, with much of the initial spurt driven by the fiscal stimulus, which is benefiting consumption. Private investment remains sluggish, but should follow with a lag if the consumption recovery is sustained.
High Consumer Price Index (CPI) inflation led by rising food prices does portend a risk to private consumption. Higher food prices are ideally tackled through fiscal measures as monetary policy cannot directly address a supply-side shock. But the risk is that higher CPI inflation fuels higher inflation expectations, making it difficult for RBI to follow a complete hands-off approach. Even in terms of the currently negative Wholesale Price Index inflation, it is only a matter of time before the base effect tapers off and the output gap starts to close, shifting RBI’s focus from growth to inflation again.
With the above factors in mind, RBI is likely to start unwinding its accommodative monetary policy towards the end of 2009, or early in 2010. It is likely to start by withdrawing liquidity first via the market stabilization scheme and cash reserve ratio hikes, before it moves to policy rate hikes.
The pace and timing of the liquidity withdrawal could also depend on capital inflows. India’s improving economic outlook amid loose monetary policy abroad could result in a sharp surge in net capital inflows which, if not sterilized, could compound excess liquidity and inflation pressures. Containing inflation, managing government borrowing and ensuring that the investment cycle revives are RBI’s key challenges. Central banking is never easy, but particularly over the next 12 months RBI needs to be on top of its game.
Sonal Varma is vice-president and India economist, Nomura Financial Advisory & Securities (India) Pvt. Ltd. The views expressed are her own.
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