In the by now familiar double-act between Reserve Bank of India (RBI) governor Y.V. Reddy and financial markets, the latter ended up being surprised again. However, this time around, I am willing to bet that the governor would have been surprised at the market’s reaction. Personally, though I had expected the repo rate to touch 9% soon, I had envisaged RBI reaching there in two steps.
Clearly, from RBI’s perspective, nothing much has changed from 24 June, when repo rate and CRR were both hiked by 50 basis points each. The central bank is still focused on an “adjustment of overall aggregate demand” in order to ensure that the rise in prices of oil and other commodities leads to a relative adjustment in prices rather than a permanent rise in the aggregate price level. By revising its growth target to a central case of 8%, RBI has acknowledged that aiming for 8%-plus growth is incompatible with containing inflation. In my view, the economy’s potential growth rate is 8% and a few years of below par growth is necessary to wring out the excesses in the economy. While there seems to be lot of heartburn over a slowdown, no central bank has ever succeeded in vanquishing the business cycle while a number of central banks have ended up allowing inflation to turn corrosive.
Accordingly, RBI is right to focus on balancing demand in line with existing aggregate supply. Looking ahead, with today’s action, RBI has insulated domestic policy from any near-time spike in oil or other commodity prices. The central bank will be in a wait-and-watch mode as the cumulative 125 basis points hike in repo rate is transmitted through the economy.
I see a round of lending rate increases by banks leading to a slowdown in credit offtake. The inflation outlook has also improved with the recent correction in commodities’ prices. While I still expect headline WPI (Wholesale Price Index) to touch 13% in August, my base case scenario is for headline to moderate from thereon and touch 6.5% in March 2009. Moreover, at 9%, the repo rate has reached a level conducive with RBI’s objectives. In line with this view, I think the central bank is done with rate hikes for the financial year. Since liquidity management is critical to the success of RBI’s stance, we see CRR (cash reserve ratio) rising by another 100 bps by December.
Over the medium term, the biggest risk to inflation comes not from commodity prices but from loose fiscal policy. The reversal in the fiscal consolidation process complicates monetary management and could lead to inflationary psychology taking hold in the economy. RBI will be closely watching the extent of fiscal slippage and a failure to revert to FRBM (the targets laid down in the Fiscal Responsibility and Budgetary Management Act) by next year could lead to continuation of tight stance.
To conclude, on Tuesday the central bank took a big step forward in moderating growth impulses and containing inflation expectations. While a number of central banks have expressed concern over inflationary pressures this year, none — not even countries that had strong fundamentals to fall back on — had the fortitude to take such decisive action. RBI has underlined India’s leadership credentials in the emerging global economic order.
A. Prasanna is head of research, ICICI Securities Primary Dealership Ltd.