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India Inflation Optimism Overdone, Rate Cut Unlikely

Continuing global economic uncertainty and recent political setbacks for India's ruling Congress party has again put the onus on India's central bank, which meets on March 15, to boost investor confidence.

Passers by are reflected on the logo of the Reserve Bank of India (RBI) outside its headquarters in Mumbai on January 29, 2010. India's central bank kept interest rates on hold Friday but moved to drain liquidity from the banking system in a bid to tame surging inflation without hurting economic recovery. The Reserve Bank of India (RBI) boosted its cash reserve ratio -- the sum commercial banks keep on deposit -- by a higher-than-expected 75 basis points to 5.75 percent in what it said was a bi
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Passers by are reflected on the logo of the Reserve Bank of India (RBI) outside its headquarters in Mumbai on January 29, 2010. India's central bank kept interest rates on hold Friday but moved to drain liquidity from the banking system in a bid to tame surging inflation without hurting economic recovery. The Reserve Bank of India (RBI) boosted its cash reserve ratio -- the sum commercial banks keep on deposit -- by a higher-than-expected 75 basis points to 5.75 percent in what it said was a bi

However, the Reserve Bank of India should stay true to its job of delivering sustained low inflation . This will require the central bank to avoid cutting interest rates this week despite the deceleration in growth – in the fourth quarter of 2011 India’s economy grew at its slowest pace in three years at 6.1 percent.

It is fashionable to blame monetary tightening for the investment slump, and while it has contributed to the moderation – as it was meant to – the more important reason lies with government policy inaction and the fallout from the corruptionscandals that hurt business confidence.

There is much overdone optimism about improving inflation data and the aggressive monetary easing that it could trigger. The Wholesale Price Index (WPI), India's main inflation gauge, eased to a two-year low of 6.6 percent year on year in January due to a combination of the lagged effect of monetary tightening, a seasonal fall in food prices and the favorable effects of last year’s high base. However, the improvement in the inflation rate is somewhat artificial, as the government has avoided raising local fuel prices due to the recent state elections, despite rising global crude oil prices.

Inflation will soften further in the next couple of months but higher crude oil prices are set to create more challenges for policymakers and will make the current optimism over inflation and rate cuts by the RBI short-lived.

The price of crude oil in rupee terms is already nearing an all-time high, and greater pass through to local retail prices will be inevitable. Additionally, in the Central Budget for 2012-2013 to be announced on March 16 there will be a likely hike in taxes on both products and services to reverse fiscal laxity, which in turn will marginally add to core inflationary pressures.

Consequently, inflation will re-emerge as a worry in India after the current improvement runs its course. Latest data out Wednesday already shows an uptick with headline inflation up for the first time in five months to 6.95 percent in February.

Reserve Ratio Cut Not Monetary Easing

The cut last week of 75 basis points in the cash reserve ratio (CRR) of banks is more than the 50 basis points widely expected at the coming RBI policy meet and is mainly to address the severe liquidity shortfall in the money market. The liquidity tightness is more than what the RBI is comfortable with and this CRR cut does not signal monetary easing.

The cut is early by a few days and the reason for this is technical: Indian banks follow a fortnightly reporting cycle and a cut in CRR on March 15 would have been effective only from March 24. This would have been late as liquidity is expected to tighten from this week as quarterly advance tax payments by companies is due.

A rate action this week appears unlikely. But the repo rate, or the rate at which the RBI lends to banks, could see a cut during the central bank’s next meeting on April 17. However, the cumulative rate easing this year will be significantly smaller than the consensus of 100-150 basis points.

A scenario where the RBI is forced to raise rates later in the year if oil prices keep moving up cannot be ruled out. Lower GDP growth will limit the pricing power of the corporate sector, but the RBI will be more focused on squeezing out inflationary pressures due to oil, despite weaker economic growth.

The bottom line is that the RBI cannot be the savior of the economy this year; the inflation reprieve will be short-lived and India will have to live with a combination of sub-trend GDP growth and still-high inflation in the fiscal year ending March 31, 2013.

Rajeev Malik is Senior Economist at CLSA, Singapore. He is a regular guest on CNBC TV. The views expressed in this article are his own.