A rate cut followed by a hike!

With inflation starting to surge once the base effect is over, this could be this year?s last rate cut

It is hard to deny that that GDP growth has slowed; investment languishes, and industrial production growth has plummeted. It is also hard to deny that headline inflation has gapped down from 9.5% in November to 7% in February.

But then it is equally hard to deny that almost all this data may have nothing to do with reality. India?s quarterly GDP figures look much like rearranged components of industrial production, which, in turn, gets changed by margins (as it happened last Thursday) that rivals the Greek fiscal deficit revisions, and the old habit of raising the inflation print two months after the first release is back.

This means that India?s monetary authority picks out turning points in the economic cycle and decides on the monetary cycle virtually blindly. RBI has been complaining about the poor quality of data for long. Perhaps it is time for it to up the ante: refuse to take a policy decision, because it can?t.

This, however, isn?t happening next week. So, like most in the market, we too believe that on April 17, RBI will cut rates 25 basis points on the grounds that headline inflation has slowed significantly and that the government?s plans to reduce deficit 0.8% of GDP in FY13, which on the surface meets RBI?s prerequisite for monetary easing.

One might be skeptical of the government?s fiscal consolidation plans (as we are) or that inflation could surge again as early as April with the end of the base effects (as we fear). But it will be hard for RBI to prejudge the budget outturn less than a month into the new fiscal year. And for the central bank to ignore the slowdown in inflation and growth would be to raise doubts about the efficacy of its own policies as the monetary tightening since 2H2010 was intended to deliver precisely this: lower inflation via demand destruction.

But then what? High frequency data (even given its poor quality) suggests that growth is limping back up. Although the PMI last month softened, it still suggests that the economy is expanding. Reassuringly, new export orders in PMI remain robust, suggesting that in the coming months export growth is likely to gather strength.

But the gap down in headline and core inflation rates over the past three months is set to end. There is, however, an overriding faith in the market and in the government that while inflation is unlikely to go back to the 4-5% average of the 2000s because of continued supply constraints, the new normal is 6-7%. Barring making heroic assumptions, such as commodity prices declining sharply or Indian companies taking a significant hit on their profit margins, we find it hard to construct a scenario where inflation stays at the 6-7% level.

If GDP growth is to average 7% in FY13 (significantly lower than the government?s 7.6%), activity will need to rise from the 6.1% pace in 4Q2011. This means that demand in the economy will have to strengthen, making it easier for firms to pass on past increases in input costs (wages, excise duty, electricity charges, railway tariff, and diesel price) to final goods? prices. In sharp contrast to the WPI, the new all-India consumer price inflation accelerated to 8.8% in February from 7.7% in January, while RBI?s household survey points to inflationary expectations hardening to over 13% a year ahead. None of these suggest any significant demand destruction. And quite easily, headline inflation looks set to climbs over 9% by midyear.

And then there is the FY13 budget. RBI?s complaint over last year has been that its tightening was undone by loose fiscal policy. That?s true, but RBI?s life will not be made any easier this year either. Even assuming that the fiscal estimates are all met, the budget doesn?t even pretend to withdraw any stimulus at all.

Asset sales do not impact aggregate demand and need to be excluded (as is international practice) from revenue to assess how fiscal policy affects the real economy. Excluding asset sales, the FY12 budget outturn was 6% of GDP (not far from the 5.9% of GDP by the government?s accounting). But the planned FY13 deficit is exactly the same: 6% of GDP after taking out 0.9% of GDP in divestment and 2G and 4G sales. Indeed, the FY12 budget withdrew more demand as fiscal deficit (ex asset sales) fell from 6.7% of GDP in FY11 to 6% in FY12.

Then there are the likely slippages. The government could raise retail petroleum prices in the next few weeks and diesel prices after the budget session is over. This might add a modicum of credibility to the consolidation plan. But just do the math. If the government plans to keep to the budgeted allocation for oil subsidies, then assuming crude oil prices to average $120/barrel, diesel prices need to be raised R12-14/liter, 30% over current prices. This isn?t happening in the current political environment. Add to that the ambitious 2G and 4G sales estimate and one quickly comes to 0.5% of GDP higher deficit.

So, we fear that the April 17 rate cut may well be the last for this year. And come June-July we?ll all be talking about the next rate hike. For India to return to the high-growth and low-inflation environment of the mid-2000s, corporate investment has to revive. Monetary policy didn?t cause its demise and it isn?t its savior. The solution, alas, lies with the government.

The author is India chief economist, JP Morgan Chase. Views are personal