A machine responding to these inflation data, based on the rules laid down in the RBI Governors December Policy Reaction Function (PRF), would have raised rates:
*if the expected softening of food inflation does not materialise and translate into a significant reduction in headline inflation, or (read as and),
* if inflation excluding food and fuel does not fall (presumably both for WPI and CPI), the Reserve Bank will act, including on off-policy dates if warranted.
But the actual decision might be more complicated. The Governor, in his December policy statement, said, There is, however, reason to wait before determining the course of monetary policy. There are indications that vegetable prices may be turning down sharply, although trading mark-ups could impede the full pass-through into retail inflation. In addition, the disinflationary impact of recent exchange rate stability should play out into prices. Finally, the negative output gap, including the recent observed slowdown in services growth, as well as the lagged effects of effective monetary tightening since July, should help contain inflation. Much of this still holds. In addition, estimates of conceptual constructs like a neutral rate or potential output gap remains subject to measurement and model errors.
At the heart of the decision, once again, will be the role of interest rates both in reviving investment and in anchoring inflation expectations. Growth concerns remain, particularly given the stress in banking sector assets. Overlaid on these concerns will be the view on inflation trajectory in 2014, given the long lags for monetary transmission.
Earlier, it seemed likely that the repo rate, at 7.75%, would allow RBI to pause for the rest of FY14 and then take a call in April or after, depending on how recovery shaped out in FY15. This likelihood is lower after the inflation prints, but we think the balance of probability still is (significantly) more for a pause than a hike. The reasons are as follows.
First, if three of the four PRF conditions are met, at a time when IIP growth is -2%, and realised GDP growth for FY14 will probably also miss our 4.8% forecast, remaining well below RBIs forecast of 5%, caution should probably be exercised. Key global commodities prices are unlikely to increase significantly in the near-term, and the rupee is likely to remain stable (albeit with a large caveat on political instability), thereby preventing a spillover of imported- to general-inflation. WPI inflation is likely to trend down to 3.6% by September, with an error band of plus-minus 30 bps. CPI inflation is likely to be far more sticky, but should also drop to less than 8% by April, hovering around the 7.8 8% levels for most of the year. The average WPI inflation for FY15 is likely to be around 5.3%, down from around 6% in FY14.
Core-WPI is up only 15 bps, which might be well within a margin of error, given the measurement noise. However, the likelihood that core inflation is likely to persist at high levelsand thereby keep inflation expectations highis a major argument for using a blunt monetary policy instrument for further damping inflation. The flat core-CPI numbers are mostly due to rural CPI; urban core-CPI has been coming off steadily since September. In all likelihood, the effects of a rate hike will have much less effect on the rural demand than on the urban, with a disproportionately high impact on urban supply.
The December input and output price indications from the HSBCMarkit PMIs also indicates that pricing power remains quite weak, particularly for services. In addition, even input prices are rising slower than before.
Second, a major factor is how much fiscal spending will reduce the space for monetary policy. The deferral of a R150 billion G-Sec auction (after a R165 billion special dividend payment by Coal India) indicates that every additional rupee earned will not automatically be spent. This deferral might also be a signal of discomfort with the then-prevailing 10-year yields, but there is inadequate evidence of such a stance. However, the fact that RBI is willing to infuse more liquidity through additional term repos, and now an OMO purchase, might signal the central bank's intent to keep cost of funds relatively low based on current assessment that the strain on market liquidity is likely to remain enduring in view of the fiscal targets set for the year as well as projections for aggregate credit growth. This infusion is despite the M3 growth, currently at 15.5%.
Not that the risk of pausing on a rate hike is absent. RBI discomfort regarding diminishing credibility of its inflation fighting credentials, based on current projections of inflation, might actually force its hand. Recovery, however modest, might encourage companies to start recovering margins, so badly beaten down, by gradually increasing prices. There is uncertainty about the extent of the negative potential output gap, or effective slack capacity, which can provide a buffer for a modest recovery without stoking inflation. Household inflation expectations, when published the day before the policy, are likely to show continuing high levels.
The policy decision, as the one before in mid-December, will be a close one. However, the Governors December statements indicate that he might not take an entirely mechanistic view. He said, given the wide bands of uncertainty surrounding the short term path of inflation from its high current levels, and given the weak state of the economy, the inadvisability of overly reactive policy action, as well as the long lags with which monetary policy works, there is merit in waiting for more data to reduce uncertainty. Or, at least, in the anticipation of fiscal actions providing greater space for monetary policy.
The author is senior vice-president and chief economist, Axis Bank.
Views are personal