Monetary policy in India aims to balance the two objectives of growth and price stability.
With these variables moving in opposite directions, monetary policy has been operating in a difficult environment. The key question leading up to the policy meeting was whether the Reserve Bank of India (RBI) would choose growth or inflation.
By choosing to hike the cash reserve ratio (CRR) in an inter-meeting move, RBI had already signalled that containing inflation expectations and managing liquidity remain its priorities. The follow-up decision to keep repo and reverse repo rates unchanged has surprised the markets, but suggests that RBI is also concerned about the growth slowdown. The timing of an additional 25 basis points (bp) CRR hike was a surprise to us, but it further demonstrates RBI’s seriousness about keeping inflation in check. It should help contain inflationary expectations, with little impact on growth.
RBI’s response is prudent. A repo rate hike at this stage would have had limited impact on what is largely supply-side driven inflation but, would push growth even lower.
The US economy is already in a recession, and the headwinds from a deteriorating global economic outlook and continued stresses in the financial market are increasing.
A repo rate hike would have been a signal to banks to hike their lending rates, at a time when other financing options are already getting squeezed. A rate hike would also have increased the interest rate arbitrage between India and the US, attracting more capital inflows and requiring more sterilisation tools to “mop up” excess domestic liquidity.
We judge that by adopting a wait-and-see approach, RBI has given itself more flexibility.
There is a risk that high commodity prices start feeding into core inflation and raising inflation expectations, but there is no clear evidence of it yet. Hence, by striking a hawkish note, RBI has made it clear that it will stay vigilant and act decisively in the future, if the second-round price and wage effects materialize.
On the other hand, RBI has also left its options open in case easing global commodity prices, a good agriculture output this year or the supply-side measures taken by the government put downward pressure on inflation in the coming months. Given this uncertain outlook, the RBI policy is attempting a fine balancing act.
RBI’s gross domestic product (GDP) growth forecast for FY09 is a robust 8-8.5%; we are less optimistic, expecting GDP growth to slow to 7.6% in FY09. Further, we expect average WPI inflation to be a much higher 6.9% in FY09 versus 4.5% in FY08 because of firm global commodity prices. Given the supply-side nature of inflation and our forecast that GDP growth will turn out weaker than RBI’s forecast, we expect repo and reverse repo rates to remain unchanged in 2008.
However, with interest rates still much higher than in the US, liquidity management arising from strong capital inflows is likely to remain a challenge and we expect RBI to hike the CRR by at least a further 50bp before this year is out.
Sonal Varma is India economist for Lehman Brothers.