The task before the Reserve Bank of India (RBI) as it prepares to unveil the second quarter review of monetary policy is tricky. Headline wholesale price inflation (WPI) continues to be sticky, close to double-digit levels in provisional terms. Although manufacturing and core WPI inflation have moderated in sequential terms, year-on-year, or y-o-y, figures continue to rule well above RBI’s medium-term targets.
On the other hand, some growth indicators have started worsening at a faster pace than was initially anticipated by RBI and the government. Though industrial production data appears to be riddled with inconsistencies, the trend in manufacturing output growth is indisputably slower.
Survey measures such as PMI readings may have magnified the extent of slowdown possibly due to sampling bias, but the direction is consistent with the overall picture. While direct tax collections have held up well (in gross terms), excise and customs collections have reportedly slowed down drastically in September, even after accounting for the duty cuts on petroleum. The only bright spot seems to be the export numbers although doubts aired by analysts about the veracity of the data will be causing some disquiet for RBI.
Throw in the backdrop of continuing uncertainty about the resolution of the crisis in the euro zone, the upcoming rate decision is shaping up to be a close call. Notably, some of these trends were prevalent at the time of the September mid-term review also. Growth indicators had turned mixed by then and global uncertainty was perhaps more intense in September. Further, the WPI data for August was distorted by a sharp rise in gold prices; excluding these effects, manufacturing and core inflation were showing distinct signs of cooling off, albeit at a gradual pace. This led some sections of the market, including yours truly, to expect a pause in the September review. However, the central bank chose to forego a nuanced approach to inflation analysis and instead placed emphasis on the stickiness of the headline figure alongside upside risks emanating from crude prices, suppressed electricity prices and structural imbalances in the food chain. The message was that RBI is bent on breaking the back of inflation expectations and would not be averse to sacrifice some growth for that objective.
Assuming that this framework still holds, RBI will still be concerned at the behaviour of inflation. Although manufacturing prices have moderated in sequential terms, prices are still rising, causing the y-o-y numbers to turn sticky.
Further, global commodity prices, in particular oil prices, have proven to be remarkably resilient in the face of significant volatility in asset prices.
Lastly, the structural factors underpinning high inflation—government policies on rural incomes and energy pricing—are unlikely to change in the foreseeable future. Three other factors would also argue for RBI to continue with its tightening bias. Last year, around the same time, WPI inflation appeared to have peaked, leading RBI to temporarily pause its tightening in December; however, a vegetable price shock followed by a sharp rise in manufacturing prices upended all calculations and triggered a second round of aggressive tightening by RBI in 2011. A repeat of a shock in primary articles’ inflation this year cannot be ruled out, given the stickiness in food articles’ prices.
Secondly, some of the growth indicators may have been distorted by temporary supply-side disruptions in the mining, electricity and auto sectors. With these factors likely improving in the months ahead, growth numbers may show some improvement in the fourth quarter.
Lastly, the expanded government borrowing programme for the second half raises questions about the ability of the government to achieve meaningful fiscal consolidation. This, in turn, would have an adverse effect on inflation expectations over the medium-term.
All said, I expect RBI to effect one more 25 basis points (bps) hike in the repo rate in the October review, if only as an insurance measure. One basis point is one-hundredth of a percentage point.
Beyond October, the central bank is likely to hold fire as the cumulative effect of its past actions start rippling through the economy. On the growth front, I expect RBI to revise down its projection for the year, thereby recalibrating financial markets’ expectations on growth and its role in monetary policy.
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