The Reserve Bank of India (RBI) will continue with its rate hike cycle as inflation—particularly RBI’s preferred measure of core inflation, or non-food manufacturing inflation—has reared its ugly head. While the role of supply-side constraints has time and again been highlighted, the forthcoming monetary policy will be announced in a background of demand pressures leading to price rise.
Also See | Rupee (PDF)
Transmission of input prices to output prices has been leading the rise in inflation and there are no leading indicators to suggest that the transmission is over. Also, the much-ignored non-administered fuel prices are playing havoc and a fuller pass-through of higher global oil prices to administered fuel is likely to result in domestic inflation continuing to be stubbornly high in 2012. We expect Wholesale Price Inflation to average 8.5% in 2012.
The choice before RBI is to either tread the calibrated rate hike path and wait for a higher monetary policy transmission to come through, or swiftly curtail the surge in inflation and take the growth moderation in its stride.
Our choice of action will be the latter for following reasons:
•Even after taking into account the lags in monetary transmission, inflation expectations today do prove to be a key determinant of the actual inflation outcome, requiring RBI to keep the rising inflation expectations stable.
• Though monetary conditions have tightened steadily since March 2010, the pace has moderated since November 2010 on a further dip in negative real rates.
•Money multiplier has once again started creeping higher, reflective of the absence of complementarity between fiscal and monetary policy. Fiscal slippage of close to 0.5 percentage point is a likely scenario in fiscal 2012 as the basic assumption of lower subsidies and high GDP growth are likely to go wrong.
Given steeper rate hikes, growth is bound to get affected in the longer term, early signs of which became evident in the GDP numbers for third quarter in 2011. Also, a decisive rise in crude oil price can be a drag on GDP. The positives still lie in the services sector. The data of Centre for Monitoring Indian Economy (CMIE) suggests that investment momentum in trade, hotels, transport, and communications—the biggest contributor to GDP growth—continues to be strong. And so does consumption.
Our analysis hints at a strong positive correlation between inflation and growth during periods of below-trend growth. Though GDP growth has now moved above-trend, we feel rising incomes and lower leverage of households are likely to postpone the negative effect of rising interest rates on consumption. Hence, growth is bound to moderate though the tailwinds may prevent a hard landing.
In sum, we feel that the growth-inflation trade-off, that RBI saw clearly tilted towards intensification of inflation in the last policy, not only continues to hold, but also now demands a deviation away from the calibrated approach.
The focus on spillover has become all the more relevant in the current scenario where high energy intensity may also be a source of volatility in inflation. Some cyclical moderation in food prices, when structural food inflation is edging up, can hardly be overemphasized. Higher-than-trend core inflation signifies a stronger spillover.
We expect RBI to hike repo and reverse repo rate by 50 basis points (bps) and we call for a cumulative rate hike of 100 bps in 2012. One basis point is 0.01%. RBI is likely to acknowledge growth moderation and keep its baseline projection for real GDP growth in 2012 at 8%. The baseline projection of WPI inflation for March 2012 will likely be placed at 5.5% in anticipation of fuller monetary policy transmission by then and also following a positive base effect.
Our analysis on domestic and systemic liquidity for 2012 reveals that even after accounting for 18% growth in deposits and credit growth moderation in line with RBI’s indicative projection (expected to be placed at 20%), the scope of a hike in banks’ cash reserve ratio is limited, assuming that government spending continues to crowd out private investment.
The writer is an economist at ING Vysya Bank Ltd.
Respond to this column at firstname.lastname@example.org