In addition to the growth woes, nervous financial markets and adverse newsflows regarding slippages in fiscal deficit and external current account clearly shaped policy expectations of the market towards market-friendly outcomes, viz., a cut in the CRR and repo rate.
Most economists and the RBI thought otherwise. The simple explanation was that the bugbear of 2011 elevated and sticky inflation seemed to remain untamed.
However, with signs of sequential momentum in inflation easing and, more importantly, investment showing a sharp deceleration, the broad consensus towards an end of monetary tightening had evolved. The RBI, too, had provided a guidance to this effect on October 28 . Living up to the guidance, RBI left both the repo rate and CRR unchanged. The policy announcement marks the first pause in the interest rate hiking cycle in the year 2011.
The tone of the policy document suggests that concerns on economic growth, especially the deteriorating investment climate, have now started attracting greater policy attention vis--vis inflation.
On the inflation front, incoming data has started providing some comfort with food prices declining for six consecutive weeks. Additionally, the deceleration in growth momentum has closed the output gap, leading to a decline in pricing power. Going forward, inflation is likely to decline to a 6.5-7.0% range by March 2012 and remain below 7% on an average basis in FY13.
On the growth front, the Q2 FY12 GDP growth slipped below 7%, the first time in over two years. This was mainly on account of a sharp moderation in industrial growth. The IIP for October added to the bearishness as growth slipped to a 32-month low of -5.1%. Other leading indicators of economic activity like PMI and external trade are also pointing towards a somewhat similar loss in growth momentum.
The global environment continues to be dismal. Despite the announcement of positive measures in the recently concluded EU Summit, the combination of a recession-like situation, need for fiscal austerity, bank deleveraging and short-term funding pressures are likely to ensure that global economic and financial conditions remain fragile in 2012. These developments are likely to provide additional downside risks to emerging market economies.
Going forward, concerns on the domestic front are likely to outweigh the global environment in shaping the future course of policy. In this context, the RBI decision to hold rates steady and, at the same time, unambiguously hinting towards a reversal in the tightening cycle seems appropriate.
A decline in inflation towards the end of FY12 will provide RBI the necessary legroom to start addressing growth risks through rate action. Starting March, we expect the RBI to cut rates by 100-150 basis points during the course of 2012. Once again, monetary easing is likely to become the first line of defence.
The writer is chief economist, Yes Bank