Central bank backs itself into a corner

Central bank backs itself into a corner

The central bank stuck to its message and hiked the repo rate by 25 basis points (bps) to 8.25% in its mid-quarter review. A small minority in the financial markets, including yours truly, had looked for RBI (Reserve Bank of India) to skip a beat from its metronomic rate hikes. My view was based on a combination of factors such as heightened global uncertainty, RBI’s success in getting ahead of inflation expectations with its aggressive rate action in May and July, and the peaking out of inflation momentum.

Of these factors, RBI acknowledged the worsening of global outlook and the likely impact it will have on exports and GDP (gross domestic product) growth. However, RBI is not convinced that it has capped inflation expectations. Nor has it acknowledged that inflation momentum has slowed down.

While I agree that inflation, in particular core inflation, has turned sticky, inflation momentum has slowed down considerably in the current fiscal year.

Thus, in the five months from March 2011, sequential core inflation has risen at a 2.6% annualized rate compared with the 12.5% annualized rate in the six months to March 2011.

Similarly, sequential WPI (Wholesale Price Index-based) inflation has slowed down to a 5.3% annualized rate in the current fiscal year compared with 13.5% in H2FY11. Further, core inflation, or non-food manufacturing inflation, has been distorted by a disproportionate rise in gold prices. Thus, gold prices have contributed 14.2% and 20.3% to the rise in manufacturing and non-food manufacturing prices, respectively, in the April-August period.

More pertinently, the gold price rise contributed fully 46.7% and 60.7% to the rise in manufacturing and core prices in August.

Now, this distinction matters because the central bank seems to have placed emphasis on the fact that core inflation edged up in August compared with July. My calculations show that but for the effect of gold prices, core inflation would have flattened out in August over July.

Given that gold has turned into a speculative asset class, its inclusion in the inflation basket is questionable. Of course, RBI did not see inflation in this light. Instead, it appears to have based its decision on rising year-on-year headline/core inflation.

However, by equating an anti-inflationary stance with a rate hike, RBI has backed itself into a corner. It is likely that the September WPI inflation will be around 9.8% and core inflation may be 7.8%, both of which will look worse than the August readings.

As a result, RBI may be forced to deliver another 25 bps of repo rate hike in October, in line with its reaction function that places a high weight on near-term inflation optics. That would be unfortunate, as I think that the prudent course of action for RBI now should be to enforce its stance by way of hawkish talk coupled with a pause.

That would allow for the lagged effects of past actions to play out even as it gives RBI some flexibility to react in case euro-zone problems spin out of control.

Bottom line: RBI has decided to maintain its single-minded focus on inflation and has eschewed nuance. A key test for this stance will come in H2, when RBI may have to address excessively deficit liquidity conditions. Should the central bank choose to buy government bonds in the open market, then its anti-inflationary stance may be compromised and could lay the seeds for further worsening of inflation expectations.

A. Prasanna is chief economist at ICICI Securities Primary Dealership Ltd.

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