Home / Politics / Policy /  RBI may raise interest rates as inflation spikes, factory output falls

New Delhi: India’s factory output contracted for the first time in four months in October and retail inflation rose to the highest since January 2012, paving the way for a possible interest rate hike next week by the inflation-sensitive Reserrve Bank of India (India).

The Index of Industrial Production (IIP) contracted 1.8% in October after expanding 2% in September, while inflation measured by the Consumer Price Index (CPI) accelerated to 11.24% in November from 10.17% in October.

RBI governor Raghuram Rajan, who is set to announce his monetary policy review next Wednesday, said that though the economy was weaker than the central bank would like, inflation was also higher than what RBI is comfortable with.

“As far as the inflation goes, we are very uncomfortable with the current level of inflation," he said. “I have said that at 10.1% and I will again say it at 11.24%."

Rajan added that RBI would take all data into account, noting that wholesale price inflation data was due on Monday.

“In a situation where you have high inflation and low growth, you have to calibrate policy carefully," he added in a briefing in Kolkata. “There are some trade-offs that we have to make."

To be sure, the contraction in factory output was largely because of the base effect (high growth last October), and November may be different.

The decline in factory output in October was driven by contraction in manufacturing and mining production by 2% and 3.5%, respectively, while electricity production expanded 1.3%.

Production in as many as 10 out of the 22 industry groups was lower compared with the same month a year ago. Some of the key industries in which production fell include: office, accounting and computing machinery (-27.2%); radio, TV and communication equipment and apparatus (-23%); and furniture manufacturing (-28.9%).

In October, the volatile capital goods segment, which represents investment demand in the economy, expanded by 2.3% while consumer goods continued to contract, by 5.1%, mostly due to a decline in production of consumer non-durable goods.

The double-digit retail inflation in November was driven by a 14.72% increase in prices of food and beverages, while an 8.94% rise in prices of clothing, bedding and footwear also contributed.

Although monetary policy is widely accepted as an instrument to contain inflation, it is a rather blunt instrument, finance minister P. Chidambaram said on Wednesday, although the only one available to the monetary authority. “It is also widely accepted that monetary policy has little impact on food prices."

On Wednesday, Rajan said that while inflation is largely concentrated in food and services, one should not spend much time debating the sources of inflation. “But ultimately, inflation comes from demand exceeding supply, and it can be curtailed only by bringing both in balance. We need to reduce demand somewhat without having serious adverse effects on investment and supply," he said.

Madan Sabnavis, chief economist at CARE Ratings, said the IIP number shows that an expected revival in the festival season months had not quite happened, with consumer durable goods registering negative growth rates. “There was some positive increase in growth in capital goods, but in the electrical segment, there was a negative base effect," he added.

In India, sales of a variety of products and services expand in the festive months of October, November and December. Diwali, India’s biggest festival, falls in this period—it was in October in 2012 and November this year.

Indranil Pan, chief economist at Kotak Mahindra Bank Ltd, said though there are growth concerns, “one cannot expect the RBI to wave a magic wand and revive the economy. It has to operate within these given restrictions".

Sabnavis said the sticky inflation scenario would be a guiding factor for RBI in formulating its monetary policy in the coming week. “We expect RBI to announce a 25 basis points (bps) hike in key policy rates at its mid-quarter monetary policy review on 18 December. However, a 50 bps hike would not come as a surprise given that the high numbers for retail inflation in November," he added.

Pan also expects RBI to raise policy rates by 25 bps. A basis point is one-hundredth of a percentage point.

India’s gross domestic product (GDP) expanded 4.8% in the three months ended 30 September, compared with 4.4% in the preceding quarter.

The finance ministry expects GDP to grow 5-5.5% in the year to 31 March. The economy grew 5% in the last fiscal, the slowest pace in a decade, as companies put investments on hold and consumers cut back on spending in the face of high borrowing costs. Delays in mandatory government approvals hurt company cash flows, stalling projects.

India’s sovereign rating could be downgraded to junk status next year if the government, in the run-up to the general election due by May 2014, does not take measures to revive stalled structural reforms, faltering economic growth, and the lower the stress of subsidies on state finances, Standard and Poor’s said last month.

The rating agency maintained its BBB minus rating with a negative outlook on India, its lowest investment grade.

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