Dovish action accompanied by a hawkish guidance

Written by Shubhada Rao | Shubhada Rao | Updated: Apr 18 2012, 09:04am hrs
The Reserve Bank of India delivered a 50 bps cut in the repo rate, larger than expected by us or the market, but broadly in line with our expectation of frontloading the rate cuts. The Reserve Bank of India in the preceding monetary policy review in March 2012, while maintaining status quo on rates, had provided guidance for future rate cuts being contingent on governments steps towards a credible fiscal consolidation. In contrast, the rate action in the Annual Monetary and Credit Policy appears preemptive as it has now put the ball squarely in governments court to deliver its intent on fiscal consolidation and growth revival in an expeditious manner. Thus, by being proactive rather than reactive, the Reserve Bank of Indias monetary action is a clear departure from its past positioning.

In a marked contrast, the policy has delivered a dovish action accompanied by a hawkish guidance. The last few quarters have been a testimony to sequential moderation in growth slipping well below the trend rate. While consumption remained the linchpin of economic growth, it was largely supported by fiscal largesse. Now with urgent need for fiscal consolidation, the consumption led growth appears vulnerable. Deterioration in investment climate along with declining exports amidst a weak and uncertain global environment, have added to the downside risks to growth. In addition, with headline inflation correcting by almost 200 bps in Q4 FY12 over the preceding quarter, and more importantly core inflation slipping below 5% in March prompted a dovish action by the central bank. Furthermore amidst weakening domestic demand conditions and softening non-oil commodity prices, pressure on core inflation going forward, is likely to remain muted as manifested by declining pricing power of non financial corporates.

The guidance however rightly remains hawkish. Managing headline inflation poses multiple challenges in a supply constrained economy. As articulated by the Reserve Bank of India, the elevated level of crude oil prices and pending adjustments to domestic administered petroleum prices, coupled with suppressed inflation in the context of coal and electricity prices and recent depreciation in Rupee, pose significant upside risks to headline inflation. Furthermore risks of fiscal slippage owing to inefficient subsidy management combined with undershooting of revenue targets may result in additional burden on government borrowing thus crowding out the productive private credit demand.

At this juncture the RBI action needs to be urgently complemented with prompt steps by the government to stimulate business confidence by focusing on mitigating supply bottlenecks through structural reforms.

With a hawkish guidance, we believe there is limited room for additional monetary policy easing going forward. We were expecting a cumulative cut in repo rate to the extent of 50-75 bps in FY13. After todays policy, we are of the opinion that the Reserve Bank of India has covered most of the expected policy easing ground for FY13 in a front loaded manner. While another round of a rate cut albeit of a smaller magnitude remains on the table, the timing would be contingent upon governments timely adherence to path of fiscal consolidation as outlined in the Union Budget FY13. As such we expect the RBI to remain in the wait and watch mode during the first half of the fiscal year. The complementarity of fiscal policy response with the monetary policy stance is what will prompt the RBI to consider further monetary policy easing.

The author is chief economist with Yes Bank