RBI runs risk of taking growth to below comfort levels

Written by Shubhada Rao | Shubhada Rao | Updated: Jul 27 2011, 07:06am hrs
The Reserve Bank of India in its first quarter review of Monetary Policy on Tuesday surprised by delivering a 50 basis point hike, pushing the repo rate to 8%. Sticky and stubbornly high headline inflation has prompted a renewal of an aggressive stance; following a gradualist approach adopted in its mid-quarter review in June. Interestingly, the cumulative hike of 125 basis points in a short span of three months coincides with economy witnessing incipient signs of moderation. With the move, RBI has preferred to remain hawkish till such time there is evidence of sustainable downturn in inflation.

The underpinnings of maintaining a hawkish stance arise from the upside risks to headline inflation emanating from an uncertain outlook for crude oil prices, direct and indirect impact of June fuel price hikes, significant outstanding under-recoveries of subsidized fuel, performance of south-west monsoon in the near term.

With risks to inflation not only lying to the upside, but also remaining unbounded, the RBI continues to provide topmost priority to anchoring inflation expectations amid limited and bounded downside risks to economic growth. However, we believe that the aggressive policy stance in a correcting course of growth when the impact of past rate hike is still playing out, runs a risk of taking growth to below comfort levels.

As the aggressive rate action coincides with a correcting growth cycle, the back-loaded rate action is likely to have spillover effects on next financial years growth prospects as well.

Going forward, RBIs ability to tighten further would become challenging as the efficiency of transmission mechanism is likely to get diluted amid moderating credit and demand conditions. The RBI will need to balance the near term growth correction with its medium term inflation objective. The monetary policy action will need to cautiously weigh the pros and cons of the effectiveness of further rate actions on managing aggregate demand in the economy amid expansionary fiscal policy.

The RBI tone does, however, seem to suggest that the tightening cycle is yet to peak and given the ultra hawkish rhetoric, we expect the RBI to deliver a 25 basis point hike in September, following which it may prefer to be guided by incremental data.

The writer is chief economist,Yes Bank