March may be too early for RBI to cut policy rates

Headline inflation have come in at a relatively comfortable 6.55% for January, thanks to the high base effect.

Moreover, manufactured inflation have risen by just 0.4% month-on-month. But, while it has eased significantly, non-food manufactured products inflation remains fairly elevated at 6.7%. That?s the number that the Reserve Bank of India (RBI) is tracking to see whether inflation is in control.

It must be a relief to see the print at below 7% ?even in December it was a high 7.7%. What has driven it down is a broad-based slowdown across most components, particularly textiles, transport equipment, and basic metals as also some support from the 7.2% rise in the value of the rupee.

Core inflation has stayed above 7% for eleven consecutive months, compared to its long term average of about 4%, before the current surge.

So the central bank would be happy to see that the 0.1% m-o-m seasonally adjusted rise in core inflation in January is sharply lower than the 2011 monthly average of 0.6%. However, even if inflation ends up at 7% or below in March, the central bank might not cut policy rates before April.

As Rohini Malkani of Citigroup points out, core inflation is likely to be influenced by the interplay between commodity prices and the currency.

Indeed the sharp drop in the value of the rupee had pushed up prices of imported inputs and finished goods, the impact of which overwhelmed the weakening demand in the economy leaving price pressures ?significant?. With the rupee relatively stable at around R49.50-50 levels, imported inflationary pressures may be abating.

However, the price of crude oil remains high at $117 to the barrel and as the central bank keeps reminding us, there?s the suppressed fuel inflation in the economy. To what extent the government will pay heed to the RBI?s advice to get rid of it remains to be seen.

In the meanwhile, there?s little chance the minimum support price, for agricultural products will come down. Moreover, wage for unskilled labourers in rural areas have been rising at a rate higher than inflation for more than two years now and even in the formal sector staff costs have risen at a faster rate since mid-2009-10. Since productivity hasn?t kept pace the rise in wages has been inflationary.

Most of all, the RBI would want to watch how the government balances it Budget for 2012-13; in the current year it will end up borrowing around R90,000 crore more than it had planned to and economists reckon the fiscal deficit would end up at around 5.8% of GDP.

A high quantum of government borrowings could crowd out private sector borrowings and keep interest rates high. The increasing revenue deficit will further strain the fiscal situation and hurt the government?s ability to make capital expenditure. The central bank has been constantly reminding the government about the need for fiscal disciple as also the need to channel funds into investments and to trim consumption expenditure.

The RBI has been concerned about slowing growth and particularly investments; factory output grew at just 1.8% in December with the capital goods piece contracting 16.5% y-o-y.

But the indicators for January have been more encouraging– according to the OECD?s leading index for India, the economy has officially transitioned from a slowdown to a recovery. So while there may be no big spike, the economy may be coming out of the trough. Should the trend sustain it will give RBI time to make up its mind.