Column : Surprise with a deep monetary policy easing

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SummaryWhy RBI will start cutting rates, maybe even more than expected.

The Macro Development Report reiterates “that the balance of macroeconomic risks suggest continuation of the calibrated stance while increasingly focusing on growth risks”. Translated, RBI will probably cut the repo rate by 25 basis point today. But there is a significant case for deeper cuts. Deeper cuts? Any economic analyst advocating deep monetary policy easing action when at least one of several inflation indicators is flashing red must surely be blinkered on basic central banking principles. But let us lay out the case for this.

First, despite a series of price rationalisations that have reduced the degree of suppressed inflation, the WPI inflation trajectory is firmly lower than earlier projections, and current projections indicate that it is likely to drop below 7% by March 2013, below the 7.5% projected by RBI in October. Remember, that the September 2012 diesel price hike was likely to have added about 7 points to the fuel sub-index of the WPI, and 1.5 points to the headline WPI, but there were negligible second rounds effects in October, contrary to expectations. “Core” (i.e. non-food manufacturing inflation) is down to 4.2% (and looking to drop further in the next 9 months).

Then, there is the trajectory of WPI inflation, which was earlier expected to peak in December, but which now appears to have topped out in September. On a downward trajectory, it is unlikely that there will be major revisions in the provisional index numbers. If things go according to plan, the rupee is likely to strengthen, which will further tamp down inflation. Money and liquidity indicators are weaker than projected by RBI.

But despite all this, consumer price inflation still remains close to 11%. Some part of the persisting high food price inflation (food is 50% of the combined food basket of the CPI) is due to a base effect of low to negative food inflation in December and January a year ago. Constraints on production of “protein” items like poultry, eggs, milk, etc, due to electricity shortages in key producing states adds to the problem. But the underlying drivers for this broad-based increase are still in place. Rural wages are still increasing at 17% (although down from 23% a few months ago), a phenomenon that is only partially explainable, despite MSP of rice having increased by 16% in 2012 (other government subventions have stabilised or reduced).

The manifest concern with all this is the effect of a wage-price spiral,

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