RBI may refrain from rate cuts

RBI may refrain from rate cuts

It is safe to say that there is some divergence of opinion about what the Reserve Bank of India (RBI) decides in its July policy review. Although the analyst community is more or less convinced that there will be no change in key policy rates, price action in bond and swaps markets suggests an implicit bet on a repo rate cut.

The European sovereign debt crisis has lingered on for more than two years and there is no solution in sight. That is because the euro elite specialize in improvising stop-gap solutions and adamantly ignore fundamental problems. Although the default expectation should be for the monetary union to endure with one more temporary measure, the next two months could prove especially challenging. Spanish bond yields are at unsustainable levels, while decisions have to be made on further support to Greece and the launch of the European Stability Mechanism. A disorderly outcome is likely unless Germany is prepared to go the extra mile.

The other reason for the confusion on monetary policy is the apparent dichotomy between domestic growth and inflation outlooks. On top of the investment slowdown, we may have to contend with slower consumption and weak external demand. Consumption demand was already getting affected by high inflation and slowing income growth; the sub-par monsoon conditions and the likely shortfall in agricultural output may also have some knock-on effect.

Global trade has decelerated appreciably over the last few months and Indian exports cannot be an exception to this trend. The only silver lining for exporters is the sharp rupee depreciation in recent times, but its effects may be felt with a lag. All said, the economy could witness one more year of sub-par growth with the tail risk of a disorderly outcome in Europe leading to a global demand shock.

Despite such a muted growth outlook, Indian inflation readings continue to be stubbornly high. To be sure, manufacturing inflation and non-food manufacturing inflation that RBI looks at closely have come off from elevated levels and are now around 5% year-on-year. This suggests that domestic demand conditions and the correction in global commodity prices have had a salutary effect on firms’ pricing power.

However, wholesale price inflation is above 7% and the risks are tilted to the upside. Some sections of the market believe that RBI should take heart from the fall in the manufacturing or core inflation and accordingly ease policy to support growth. However, there are a number of issues with such an approach.

First, there is the issue of retail-level inflation at, or close to, double digits. With such a significant wedge between wholesale and retail prices and consumer inflation expectations likely being shaped by the latter, any attempt to declare victory over inflation on the basis of core inflation could backfire.

Second, wholesale price inflation may well be understated as it fails to reflect the recent electricity price increases; further, the prices of an array of items such as petroleum and fertilizers may rise in the coming months. This could push up manufacturing prices also over a period of time.

Lastly, non-food manufacturing wholesale price inflation is a poor proxy for core inflation in my view. Exclusion-based measures of core inflation may not be the best indicators of underlying inflation and should be handled with care.

Indeed, my analysis shows that a statistical measure of core inflation for the Wholesale Price Index (WPI), the Trimmed Mean WPI, is ruling close to 6%, suggesting that underlying price pressures are yet to abate completely.

From a central bank’s perspective, it is unfortunate that slowing growth is being accompanied by stubborn inflation. However, this unpleasant outcome and the prevalent macro pressures should be traced to the high fiscal deficit being run by the government. Thus, we are following a sub-optimal policy mix, which cannot be corrected unless the government decisively cuts the fiscal deficit and puts the country back on the path of fiscal consolidation. Till that time, RBI may have no choice but to refrain from cutting rates. The central bank can, perhaps, point to the fact that it has already done its bit for the economy with the April rate cut and a proactive liquidity management strategy.

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

(The Reserve Bank of India will announce its first quarter monetary policy review for fiscal 2013 on 31 July. This is the sixth and last of a series of articles by eminent economists on what to expect from the policy)