The perception in the market before the 25 October monetary policy of the Reserve Bank of India (RBI) is that we are very close to the peak of the rate hiking cycle, although the possibility of another rate hike next week cannot be ruled out. Apart from the rate decision, we will also be looking for any subtle or explicit change in the guiding principles of monetary policy because the economic cycle is changing. There are always multiple considerations that go into framing monetary policy, but in our view, belief in three hypotheses has prompted RBI to adopt a more hawkish policy stance in FY12.
First, low and stable inflation encourages investment and promotes growth over the medium term. In this context, a recent RBI working paper estimates that inflation can retard GDP (gross domestic product) growth if it stays above the 4-5.5% threshold. So the target of monetary policy should be to keep inflation below this threshold and high inflation cannot be tolerated in search of higher growth. Needless to say, inflation has been much above that threshold for a sustained period of time.
Second, near-term growth might have to be sacrificed to keep inflation under check. This hypothesis connects well with the idea of engineering a calibrated soft landing where the economy might have to grow at below the potential growth rate for a while to moderate demand side pressures.
Third, monetary policy is effective in not only bringing down demand-side price pressures but also tackling persistent supply-side shocks which dehinge inflationary expectations.
At this juncture, we probably need to delve a little deeper into some of these hypotheses. For example, while evaluating the second hypothesis there is considerable uncertainty over whether the potential growth rate of the economy has already been adversely affected by lack of supply-augmenting reforms. Most analysts peg the potential growth around 8% but there is a downside risk to that estimate. Also, it is not clear how far below the potential growth rate, RBI will let growth fall. It is quite likely that in the October policy, RBI will be more explicit in acknowledging that growth moderation has occurred but it will probably be difficult for it to give even a subtle hint of whether the extent of slowdown has crossed its tolerance limit.
However, there are two important considerations in deciding the timing of a pause in RBI’s quest for an engineered soft landing.
Monetary policy works with a long and uncertain lag, especially in developing countries such as India. So, RBI is likely to pause much before inflation actually falls close to its comfort level. Unfortunately, in late 2010 when RBI paused, inflation flared up again prompting its current worries about a “pre-mature” exit from its anti-inflationary stance.
The second factor is the ability of monetary policy to perfectly fine tune the moderation in growth. Once growth starts slowing, a set of chain reactions can trigger a much sharper decline in growth than anticipated, especially when the investment climate is buffeted by global uncertainties. Inflation management does require sacrificing near term growth but allowing growth to drop beyond a threshold could come with its own set of problems.
Persistent inflation is also posing the difficult question of whether interest rate hikes are having the desired impact. It is tough to say what would have happened to inflation if rates had not been raised aggressively. Still, stubborn inflation can change people’s perception about effectiveness of monetary policy and complicate matters.
I think RBI will hike rates by another 25 bps (basis points, or 0.25 percentage point) in the 25 October policy because of uncomfortably high inflation and uncertainty over whether hidden price pressures can derail the early signs of inflation finally coming under control. A signal that the balance of risks is getting spread more evenly between inflation and growth is likely to precede a pause in the rate action. For that, growth data needs to worsen further or RBI needs to recalibrate its guiding principles.
Samiran Chakraborty is head of research, Standard Chartered India
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