Central bank playing with fire2 min read . Updated: 17 Apr 2012, 08:58 PM IST
Central bank playing with fire
With gross domestic product (GDP) growth dropping to its slowest pace in three years, investment growth turning negative and industrial production growth plummeting, boldness was expected from Delhi. Instead we got the Reserve Bank of India (RBI) playing with fire.
Hastily, the central bank raised its March projection for inflation from 5.5% to 7% only to see it end at 9.7%, and then went into a tightening binge to compensate for lost time. The rate hikes ended in October, six months after the pace of core inflation had peaked in March.
Today’s 50 basis points (bps) rate cut could well turn out like the pause in December 2010. The fall in inflation from 9.5% in November to 6.9% last month is set to end. There is, however, an overriding faith in the government and RBI (based on its projections) that inflation will remain this year in the 6-7% range.
Barring heroic assumptions, such as commodity prices declining sharply or Indian companies letting their margins get squeezed further, continued input cost increases (wages, excise duty, electricity charges and railway tariffs) are likely to push up inflation, breaching 7.5% as early as April. By mid-year, we could be looking at a 9% inflation rate helped by a likely diesel price hike in May and the end of the base effects.
What makes the rate cut risky is that apart from disregarding history in the belief that it won’t be repeated, RBI seems to be flirting with experimental medicine. In changing its monetary stance, the central bank states that one of its goals is to keep inflationary expectations in the 4-4.5% range.
The central bank’s other goal in changing monetary policy is to make rates “consistent with the current growth moderation". But where is the moderation? Not in RBI’s projection. It expects growth to average 7.3% in fiscal 2013. At present (the last data point we have), growth is running at 6.1%. Moving from 6.1% in the fourth quarter of 2011 to an average of 7.3% in fiscal 2013 implies a pretty strong expansion.
This is where the real danger lies. High-frequency data (even with its astonishingly poor quality) suggests that growth is limping back. Acceleration in the new all-India consumer price inflation to 8.8% in February from 7.7% in January reinforces that demand remains fairly strong.
There are risks of crude prices rising and the rupee depreciating. RBI’s complaint over last year was that its tightening was undone by loose fiscal policy. Given the likely slippages on oil subsides and spectrum sale, the fiscal deficit could end half a percentage point higher than budgeted, adding to demand and pushing up inflation.
So, today’s rate cut may well be the last for this year. The April inflation print that comes out mid-May will be the first sign that inflation is back. And come June-July, we could be talking about the next rate hike. Perhaps RBI, too, is aware of this as it defensively states that “these considerations limit the space for further reduction in policy rates". But then one wonders—why cut rates at all?
Jahangir Aziz is India chief economist, JPMorgan Chase.
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