Towards tighter monetary policy

Towards tighter monetary policy

The Reserve Bank of India’s decision to hike key policy rates by 25 basis points (bps) was in line with expectations. The probability of a more aggressive 50 bps rate hike had risen in the last few weeks, but RBI’s decision to stick to a calibrated approach suggests that the central bank, while clearly worried about inflation, also wants to support the economic recovery. There is also a growing recognition that there are limits of how effectively monetary policy can control inflation when structural bottlenecks persist.

There have been two significant changes in the macroeconomic environment since RBI’s 16 December policy meeting, when rates were kept on hold.

First, developed-world growth prospects look brighter. Better global demand has benefited India through an improvement in export growth. In addition, with emerging economies continuing to do well, global commodity prices have inched higher.

Second, the domestic inflation outlook has worsened. A rise in vegetable prices due to unseasonal rains was the main trigger for the rebound in inflation. There have been recent signs that vegetable prices are moderating, but a rising insensitivity of food prices to monsoons, a global surge in food prices and a structural rise in the prices of protein-rich food items suggest that primary food inflation is unlikely to fall by much.

Moreover, non-food inflationary pressures are building. Households’ inflation expectations have been rising. Rising input costs have led to margin pressure for firms and they may pass on some of their higher costs to consumers.

A rise in domestic fuel prices is pending, which will add to higher transportation costs. Moreover, fiscal policy continues to be expansionary and may be diluting some of the monetary policy effectiveness in controlling inflation.

The government’s decision to hike minimum rural wages will add to inflationary pressures. Against this backdrop, not only are there upside risks to RBI’s revised Wholesale Price Index (WPI) inflation projection of 7.0% by March 2011, but also to the inflation outlook next year.

RBI’s objective until a few months back was to normalize policy rates and bring them closer to neutral, from very loose conditions in early 2010. However, in an environment where inflation persistently surprises on the upside, policy rates have to move from neutral to the tightening zone.

Tight monetary policy by definition would mean some trade-off on growth in a bid to contain inflation. Therefore, a moderation in economic growth is likely in the year ahead. However, RBI has to balance this very carefully. Tight liquidity has already put monetary policy transmission on fast-forward.

While the repo rate is 250 bps below the 2008 peak, short-term money market rates and wholesale funding costs are close to mid-2008 levels. Investment projects have already been postponed for various reasons, and too sharp a rise in debt-funding costs could become yet another headwind. A delay in investment will only prolong the structural demand-supply gap that haunts India. While RBI appears confident on growth right now, it cannot afford to take its eye off the ball.

Sonal Varma is India Economist, Nomura Financial Advisory and Securities (India) Pvt. Ltd.