Reserve Bank loses its cool on monetary tightening

Reserve Bank loses its cool on monetary tightening

The Reserve Bank of India (RBI) unexpectedly hiked the repo rate by 50 basis points (bps), the ninth increase since early 2010 when it began increasing rates and the first of this magnitude in the current tightening cycle. Cumulatively, RBI has now effectively hiked its rates by 400 bps, with little respite on rising Wholesale Price Index (WPI) inflation. One basis point is one-hundredth of a percentage point.

The guidance in RBI’s policy statement raises some issues. One, RBI’s tone is understandably hawkish and it rightly appears ready to sacrifice near-term growth for stronger, sustainable medium-term growth in a lower inflation setting. However, it still expects credit growth of 19% in fiscal 2012. If it is attempting to moderate growth by increasing the cost of credit, why is it still relatively upbeat on credit growth, the main channel of transmission of its actions?

Two, while RBI acknowledges that the cumulative monetary tightening is being effective, it still expects WPI inflation to run around 9% year-on-year for the next few months before easing. There appears to be a disconnect between aggregate demand and WPI inflation dynamics. However, that disconnect is not surprising as WPI measures input prices, not final goods prices. Further, the anticipated increase in local fuel administered prices has nothing to do with demand, although it will affect headline inflation.

RBI gets full credit for having successfully anchored everyone’s focus on WPI inflation, even though focusing on WPI inflation for setting interest rate policy is misguided, in my opinion. It is the only central bank in the world to have this approach; all other central banks use consumer price inflation to check demand-driven inflationary pressures. These pressures impact the magnitude of the pass through of higher input prices, something RBI does not appear to have a good handle on. Indeed, if a full pass through is taking place by companies, they would not be suffering margin pressure as they actually are.

Indeed, RBI’s own macro assessment reveals that nearly three-fourths of the increase in non-food manufactured goods prices in 2010-11 was driven by three categories—textiles, chemicals and metals. All three were significantly affected by global price movements. But would the aggregate prices for the final consumer items that these inputs feed into have gone up by the same magnitude as these input prices in WPI? It is highly unlikely, in my opinion.

Inflation will remain higher for longer and RBI is not done with its tightening, although it will likely revert to 25 bps moves. But it remains to be seen what the 50 bps signal can achieve that 350 bps could not achieve.

The most disturbing part of the policy statement is para 46, where RBI extols the virtues of low inflation for several years prior to the high growth phase of 2003-08. Unfortunately, it forgot to mention that Indian industry was flat on its back for several years before that high growth phase, partly owing to the mid-1990s mishap that RBI’s monetary tightening contributed to. Hopefully, that painful period is not the template for the current framework.

Rajeev Malik is senior economist at CLSA, Singapore.

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