Some increase in diesel or LPG prices welcome, but not sufficient to initiate an immediate easing response from RBI

The June monetary policy statement of RBI was very clear in its message. ?Further reduction in the policy interest rate at this juncture, rather than supporting growth, could exacerbate inflationary pressures??the bias of monetary policy was quite evident and the RBI Governor has expressed a similar concern over inflation in other speeches after the policy. Inflation worries are well justified but the June policy statement seems to suggest that interest rates are not the principle cause of the growth slowdown and, hence, monetary policy will be ineffective in stimulating growth as long as supply constraints are not addressed. Also, RBI noted that real lending rates are lower compared to the 2003-08 period, diminishing the scope for further easing of nominal rates.

Apart from high inflation, moderate real interest rates and inability to stimulate growth through monetary policy alone, RBI has also mentioned lack of progress on fiscal front as a reason behind staying cautious on monetary policy. If these are the axioms that are forming the backbone of monetary policy decisions, then it is essential for us to see how the situation has evolved after the June policy on these parameters.

WPI and CPI for June came in marginally lower than in May and were mild surprises for the market. In fact, between February and May headline WPI stabilised in a narrow range of 7.5-7.7% and the June print of 7.25% was the lowest in 30 months if we ignore the one-off 6.5% in January 2012. However, CPI still stays in the double digits for the third consecutive month and, needless to say, the current inflation is much higher than the comfort level of RBI.

Even the outlook on inflation is cloudy. Core inflation has moderated with the growth slowdown and, in our view, can come down further over the course of the year, but that cannot be said about food and fuel prices. The growth impact of a delayed monsoon could be manageable but it is likely to push up food prices. Particularly, if evolving El Nino conditions dry up rains in August and September, then we might be staring at a drought-like situation for the monsoon season as a whole. The worst drought in the US since 1956 is already putting pressure on international prices of corn, wheat and soybean. As a result, the CRB index (a composite index for all commodity prices) is up 14% in less than a month.

Price rise has not been limited to soft commodities. Brent crude is up around 18% from its recent lows around a month back and subsidies on diesel have crossed R10 per litre. The appreciation in currency has been much lower than the upward movement in commodity prices. Imported inflation, which was drifting down in the last few months, could potentially pick up again. If we build these into our inflation outlook, then it seems to us that there would be no sustained respite from inflation till Q4-FY13. It is debatable to what extent interest rate policy is effective in countering food and imported inflation, but since RBI is showing greater concern about headline inflation and its impact on inflationary expectations, we think that any immediate monetary easing is unlikely.

Real interest rates have also not hardened after the June policy. Although the transmission of the 50 basis points reduction in policy rates done in April has not been complete, the market-linked short-term interest rates like rates on three-month certificate of deposits have come down in the recent past. There has been close to 100 bps decline in this rate from the time RBI reduced its policy rate in April. Easing of liquidity in the banking system has also aided this down move in short-term rates. In effect, RBI might not feel any urgent need to inject liquidity in its July policy. The liquidity-easing measure of the June policy is helping the system and some other specific factors could keep liquidity within RBI?s comfort zone in the near future.

Relatively high frequency growth indicators are often quite noisy. Suffice to say that growth is still languishing at a much below potential level and we might be at a flat bottom on the growth cycle. There is a growing expectation in the market that government will soon take some measures to revive the investment sentiment. RBI?s fear that rate-easing will fuel demand without an adequate supply response will be assuaged to some extent if some of the supply-side constraints are gradually removed. However, we think that the July policy will be too close for RBI to respond to any government action.

More particularly, the worries on the fiscal side still remain. Some increase in diesel or LPG prices is welcome but might not be sufficient to initiate an immediate easing response from RBI. So, there seems to be very little positive development post the June monetary policy, which can give RBI any substantive reason to lower its guard on inflation. It is true that a lot of other central banks have eased monetary policy in the last few days, sometimes even unexpectedly, (e.g. South Korea, South Africa, Brazil, China, ECB) but the growth-inflation dynamics in India are quite different from these economies. Relatively lower inflation in these economies has given their central banks the comfort to focus on growth. In India, inflation still remains the focal point of monetary policy. As the Governor has mentioned several times, sacrificing near-term growth to purge inflationary pressures would have to be accepted as the policy imperative. It is probably better to maintain this stance till inflation comes off to more comfortable levels rather than surprising the markets with a different perspective. Rate cuts, in our view, are not immediate.

The author is head of regional research, South Asia, Standard Chartered Bank