Most central bankers today are facing the dilemma of rising inflation and slowing growth. But, even though rising commodity prices and the resultant inflation are a global problem, the response has to be local. In India’s case, the Reserve Bank of India’s (RBI) decision to hike repo rates by 50 basis points was a surprise, but is a prudent response in our view.
We have seen increasing signs of second-round effects on inflation over the past two months. Rising input costs have forced producers to raise prices of manufactured products and the still-wide gap between input and output prices suggests a risk of further increases in output prices.
A wage-price spiral is not evident yet, but increases in consumer prices can lead to demand for higher wages due to cost of living adjustments. Besides, with double-digit Wholesale Price Index (WPI) inflation likely to persist, there is a risk of unanchoring inflation expectations. Therefore, between runaway inflation and moderating growth, the RBI has chosen inflation over growth.
Apart from rising inflation risks, we think RBI’s more aggressive policy move is likely motivated by three other factors. First, with worsening fiscal and current account balances, the scope for both fiscal measures and rupee appreciation to counter inflation is limited, putting the onus squarely on monetary policy to control inflation. Second, despite past tightening, aggregate demand pressures remain. RBI appears particularly concerned about the strong credit growth. And third, the only way to lower inflation is to rebalance demand and supply; if supply cannot be increased, then demand will have to be lowered. This seems to be the objective of the 125 basis points worth of repo rate hikes announced so far in 2008. The cumulative 150 basis points cash reserve ratio (CRR) hikes announced this year reinforce RBI’s tight monetary policy stance by ensuring that repo remains the binding rate corridor.
The upward revision in RBI’s inflation target from 5.5% to 7% by March 2009 makes the target much more realistic in our view.
We expect double-digit inflation to remain until February. However, we are much more bearish than RBI on growth, expecting GDP (gross domestic product) growth to slow sharply to 7.3% in FY09 from 9% in FY08, because of rising headwinds from the sharp interest rate hikes, financial market turbulence, rising commodity prices and slackening foreign demand.
In our view, RBI has front-loaded its monetary policy tightening in anticipation of much weaker growth in the coming quarters and the persistence of double-digit inflation in 2008 due to an adverse base effect and, most importantly, due to the lags involved in policy transmission. Given the aggressive policy tightening already in place, an expected growth slowdown and our house view that oil prices will drop further to $90 (Rs3,825) a barrel by Q1 of 2009, we think the urgency to hike the repo rate will be much less as the balance of risk shifts gradually from rising inflation towards slowing growth.
Therefore, we expect no further repo rate hikes this year, but expect RBI to maintain a tightening monetary policy bias by incrementally hiking CRR by another 25 basis points in Q3 of 2008.
Sonal Varma is India economist, Lehman Brothers.