RBI moves back to baby steps

Written by Indranil Pan | Updated: Jun 17 2011, 07:31am hrs
The writing was on the wall. Headline WPI inflation maintained its consistency of surprising market watchers once more by coming in at a 9.06% level for May, higher than the 8.7% being expected. Further, after a brief period of dip, non-food manufactured goods inflation once again rose back to 7.27% from 6.28% in April. Further, with the new based industrial production coming up with numbers that were better than under the old series especially that for the capital goods, there was only one direction that the RBI could go. The debate was however more to do with the extent of the increase, especially after the RBI surprised the market by doing a 50bps hike on the previous policy date on 3rd May. RBI reverted back to its baby step approach and increased the policy interest rate by only 25 bps.

The monetary policy statement from RBI left no doubt that the central bank continues to remain concerned of inflation, more so the demand related upsurges. More concretely, the rise in the non-food manufactured inflation was clearly symptomatic of sustaining demand side pressures and a more generalized inflationary trend. The RBI clearly was worried that the rising wages, costs of service inputs and the cost of general raw materials could still be passed on by the producers along the entire supply chain, implying that pricing power was intact. The recent statistics on the first two months of tax collection trends and also on the advance corporate taxes indicate that company margins may not have been eroded significantly due to the higher input costs. Further, even though RBI sees some deceleration in the interest sensitive sectors such as auto, the evidence is still not strong that the deceleration is very sharp and broad-based.

RBI, therefore, is still not done with the interest rate hiking cycle. The debate now should veer on the additional dose that might be needed to cool inflationary pressures. And this is where the dilemma might be. Clearly, money supply growth is not behind the current phase of Indias inflationary trend. Due to the higher currency in circulation and also due to the policy of RBI to increase CRR, the money multiplier has been coming down, thereby reducing the money supply growth. Thus, clearly, monetary policy alone cannot contain the current inflationary pressures.

RBI, however, clearly states that the risks to domestic inflation remain high. Indias fiscal policy has been coming in the way of monetary policy by ensuring that demand remains on the higher side. MGNREGA wages have been indexed to the CPI-AL while the MSP for various kharif crops have been increased. And supply side problems in the domestic agricultural sector do not have any immediate solution. And further, the foreign part of domestic inflation, namely the global commodity prices is also not expected to cool. The problem is that we do now talk about global growth coming off and this in effect bringing down commodity prices. However falling global growth might mean the sustenance of global liquidity, implying that commodity prices do not get much chance to moderate.

The bias towards more rate hikes is likely to continue as the RBI seems willing to sacrifice short-term growth to bring inflation under control. The quantum and timing would depend on the extent to which global uncertainties impact domestic momentum. As of now, I would factor in another 50 bps cumulative increase in the Repo rate in this cycle.

The author is chief economist, Kotak Mahindra Bank.

Views expressed are personal