Inflation Still Stands Between RBI & A Rate Cut

Dark clouds of the metaphorical variety have invaded the Indian airspace at a time when the Indian economy is desperately praying for the real thing. The monsoon deficit, which seems to be aggravating with every passing day, is now well on course to affecting crop sowing and causing a shortfall in agricultural production (read about it here and here). There are other portentous clouds on the horizon too.

Industrial production is limping along: the May numbers show a growth of slightly over 2%. But, mass-scale scepticism underlines this number because the April growth numbers have now been revised down to (-)0.9%. This is ominous: this means that industry produced less (in absolute numbers) in April this year than it did in April last year.

Courtesy: Reuters

Inflation seems out of control, though there is one proverbial lining here. The wholesale price index surged up by 7.25% in June 2012 over June 2011. While this is below the 7.55% rise in May, and also considerably below the Street consensus call of over 7.6%, it’s still way above the Reserve Bank’s comfort zone. Bad news continues to emerge from data revisions – inflation data for April has now been revised upwards to 7.5% from 7.23% announced initially. Consumer inflation for May 2012 remains highly elevated at 10.36%. But, there is still a glimmer of good news in all this: given data volatility and unreliability, RBI tracks core inflation data (or non-food manufacturing inflation) which is currently steady around 5%.

In the midst of all this, the Reserve Bank of India is expected to meet on July 31 to conduct its mid-quarter review of monetary policy. The markets don’t know what to expect: a majority wants rates to be cut, because it associates the slowdown directly with rate hikes in the past. Therefore, it holds to logic (in their minds, at least) that rate cuts will lead to a growth uptick. In addition, many central banks around the world — China, Europe, Taiwan, South Korea and Brazil — have cut rates recently and the RBI Governor will be under pressure to emulate them. However, most economists and analysts feel that it might be a bit premature to take the shears to interest rates.

So, how will Duvvuri Subbarao chose to act? While it is a mug’s game trying to predict RBI’s actions (and many a well-known face has ended up with egg on it), this blog will rise above the humdrum and deign to advise the central bank.

This blog feels that the Reserve Bank should hold interest rates at the moment. Although this same blog had argued for a rate cut in February, it is arguing against it now. There are two key reasons. One is, of course, the singular impact that such rate signalling can have on sentiments, which at that point of time sorely needed some encouragement from the authorities. But, the more important reason is the way the opportunity to climb out of the slowdown hole has been squandered. There is no visible action on a number of fronts – either on expenditure management or on implementing major policy reforms. If the rate cut then had been combined with some policy actions from the centre (as was expected then), the situation could have been ripe for another rate cut now.

There are other compelling reasons to press for a pause now. Lower agri production is likely to result in higher food prices, especially for pulses, vegetables and fruits. Simultaneously, it is also expected to translate into lower rural incomes. This will mean lower demand for a broad spectrum of goods and services (think Hero Honda motorcycles or cement for rural housing). On a macro level, this means continuing with a period of slow industrial production. On top of all this, with inflation and inflationary expectations continuing to remain high, with global volatility continuing to put pressure on capital flows and the rupee (thereby creating another distinct source of inflation for the economy), and with the government yet to put its money where its mouth is, it probably makes no sense to cut rates now.

However, the central bank is under tremendous pressure. If it decides to cut rates at all, core inflation at 5% could be a strong reason. It is worth the wait to see how the policy shapes up and trying to figure out what has influenced the eventual outcome.


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