Frustrated by the lack of support from fiscal policy and belatedly recognizing that persistent inflationary pressures are as much a demand pull as a structural food inflation story, the Reserve Bank of India (RBI) has delivered a steady diet of interest rate increases this year to bring inflation under control.

By Bloomberg

Several emerging economies, most notably Brazil as well as Indonesia, arriving at similar cyclical junctions in recent weeks have shocked investors with rapid policy u-turns and cut interest rates. The Chinese authorities have also begun to “selectively ease" policy in recent weeks. Such a rapid policy u-turn by RBI looks both implausible, not to mention unwise.

But with the risks to growth moving sharply to the downside, the Indian central bank would be well advised to resist the siren voices calling for further monetary tightening and halt the rate hikes.

Monetary policy is at its best when forward-looking. India’s inflationary woes have arisen at least in part as RBI was too slow in recognizing that 2008’s sharp but short slowdown left the economy still close to full capacity. The economy’s then-rapid re-acceleration, spurred by unusually loose monetary and fiscal policy settings, saw a “positive output gap" quickly emerge. Cyclical demand-pull inflation pressures were then inevitably superimposed atop the well-documented structural acceleration in food inflation. While the central bank can do little about the latter, the former is its responsibility. Playing catch up, RBI has doggedly pushed up interest rates with the explicit aim of producing the sustained cyclical slowdown needed to bring demand-pull inflationary pressures to heel. It is now clear RBI’s desired slowdown has arrived. Indeed, the economy may be slowing too fast. The souring growth outlook partly reflects a deteriorating external environment.

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Increasingly, tight monetary policy is producing an incontrovertible and seemingly accelerating domestic slowdown. The Purchasing Managers’ Index (PMI) surveys for September were especially soft. The manufacturing PMI survey plunged to levels not seen since early 2009 and now more than corroborates the message of the soft “official" industrial production data. The composite PMI survey, which encompasses the broader service sector, is also decidedly sub-par, dropping to a level at which RBI has typically cut rates.

Non-food bank credit has also shown palpable signs of losing momentum in recent weeks. Perhaps, most worrying is the drop off in M1 money supply growth. Growth in this key gauge of liquidity fell below 5% year-on-year in September, the slowest since 1981. The dwindling liquidity preference signalled by M1’s unprecedented weakness most likely portends lower future spending.

While any marked improvement in Wholesale Price Index-based inflation is still several months away, the latest activity data confirms that our long-held expectation for a hardish landing for the economy is now rapidly materializing. Gross domestic product growth looks on course to drop below 7% in the coming quarters. Cyclical inflation pressures, with a short lag, should begin to abate quickly. While far too early for the type of policy u-turn seen in Brazil and Indonesia, a further rate hike would be a mistake, unnecessarily adding to the rising risk of a hard landing.

The next move by RBI should be a rate cut, but not until inflationary pressures have decisively begun to subside.

Richard Iley is Chief economist, Asia, BNP Paribas

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