Market expectations from the mid-quarter monetary policy review in September have been rather low. In June and July, some part of the market, particularly bond traders, were expecting RBI to cut the policy rate to stimulate growth. However, those expectations have been tempered as incoming data has failed to show any significant improvement in the inflation situation and RBI has maintained its stance that inflation continues to remain at the top of the list of policy priorities. The communication from RBI from June onwards has been very consistent that there is a need to sacrifice short-term growth to control inflation and, at this juncture, only interest rate cuts are not sufficient to stimulate growth.
Surely, it is a positive development that, in July, headline WPI inflation dropped below 7% and CPI was lower than 10%, but they are still much above RBI?s comfort level of around 5%. Also, data issues make it difficult to draw correct inferences from these numbers. For example, CPI data showed an 8% month-on-month increase in vegetable prices in July while this fell 6% month-on-month in the WPI data. Similarly, the fuel index was up month-on-month in the July CPI while it was down for the WPI. Electricity prices in the WPI index have also remained unchanged for 10 months, whereas most of the states have substantially increased prices of electricity over this period. Anecdotal evidence does suggest that pricing power might be on a decline, but the recent spike in core (non-food manufacturing) inflation to 5.4% in July from 4.9% in June needs to be carefully monitored.
We think that the headline WPI data might be underestimating food and fuel inflation and it will be too early for RBI to signal that the battle with sustained inflation is over. The focus of monetary policy has shifted to headline inflation because persistently high headline print is keeping inflationary expectations elevated, raising risks of a wage-price spiral. The critical puzzle today is why inflation is persisting at such a high level even when growth has moderated so much.
Although Q1FY13 GDP growth data indicates that growth deterioration has probably been stalled, risks to the downside remain. FY13 GDP growth is likely to be much lower than RBI?s projection of 6.5%. So, a significant output gap is opening up if the potential GDP growth of the economy is 7.5%, as mentioned in the RBI Annual Report. Inflation, particularly core inflation, should moderate on the back of this output gap, but the process seems to be sluggish because of deeply entrenched inflationary expectations. After 1996, India has never witnessed sustained 7%-plus inflation for three years. The behavioural response to such an episode could be unpredictable. Another explanation of the puzzle could be that the potential GDP growth itself has fallen below the 7% mark as investment rate and productivity growth have suffered in an environment where supply-side reforms have been delayed. If that is true, then output gap as yet is probably not large enough to bring down inflation and more short-term growth sacrifice might be needed to put the inflation genie back in the bottle.
RBI is also worried about suppressed inflation, which is getting reflected in the burgeoning fiscal deficit and threatening a ratings downgrade. Despite repeated pleas from RBI, the government as yet has not been able to increase retail fuel prices?just one measure to show that the government is serious about fiscal consolidation and curbing its revenue spend. In the absence of such a price hike, headline inflation might surprise us on the downside, but RBI might not be swayed by that temporary respite. On the other hand, a fuel price hike, even if it pushes up headline inflation in the near term, can give RBI a reason to focus on core inflation again. Both fiscal and monetary policies cannot be loose at the same time when inflationary expectations are high.
It is well understood that growth needs to be sacrificed in the short term to curb inflation, but too slow a pace of growth might affect the pace of fiscal consolidation, funding of the current account deficit, worsen asset quality of the financial system and may even cause social tensions when aspirations are running high. Timing the shift to a more pro-growth monetary policy stance would be a decisive step that RBI will have to take in the near future, but the September monetary policy seems to be too early for that. RBI has set some preconditions for such a shift and they have not yet been met.
While the growth-inflation trade-off remains extremely challenging for RBI, the improving domestic liquidity conditions, range-bound currency movements and the readiness of global central bankers to avert any disruptive outcome by infusing liquidity do provide some respite. In our view, the September monetary policy review is going to be another ?wait and watch? event without too much guidance on how soon there will be a change in stance.
The author is regional head of research, South Asia, Standard Chartered Bank
