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Central bank unlikely to ease key rates

Recent data-points indicate that the growth-inflation mix has somewhat improved for the economy. Industrial growth in the first two months of the current financial year has rebounded to 4.03 per cent, from (- ) 1.0 per cent a year ago, supported by a sustained growth in the output of core industries. Exports, too, had strengthened in April-June, 2014.

At the same time, Consumer Price Index (CPI)-based inflation, or retail inflation, has eased from 10-11 per cent in October-November, 2013, to 7.3 per cent in June, 2014. Within this, core retail inflation has eased to 7.2 per cent, much lower than its level six months ago. Easing of inflation was not contributed solely by a base effect, as its sequential build up was also modest. So far, the retail inflation trajectory has been consistent with the path anticipated by Reserve Bank of India (RBI). Thanks to the RBI’s sustained tightening, the real deposit rates have turned positive since January, 2014.

The question is whether this comfort could be sustained, given the downside risks posed by a deficient monsoon and geopolitical risks in Ukraine and West Asia. So far, the rainfall deficiency is as high as 27.0 per cent of its long-period average. Reservoir and basin levels have turned significantly deficient by early July. While this poses a risk to kharif production, an even bigger risk is for the rabi crop that primarily depends on the irrigation/reservoir levels. This is a definite threat to food inflation, going forward. Moreover, the latest HSBC PMI, a leading indicator of inflation, showed price pressures gathered steam in June with both input and output prices picking up for manufacturing and services. Some hardening of core inflation is also expected due to the rising aggregate demand, thanks to the much-needed growth supportive policies of the new government.

As monetary policy has to be forward looking with the transmission lag of six to eight quarters to have its full effect on inflation, we expect the RBI to revert to a more hawkish stance in August versus its stance in June. Moreover, people’s inflation expectations are more sensitive to food and fuel prices and these prices have developed a significant upside risk in recent months. Given RBI’s dedicated focus to inflation anchoring, we do not expect it to reduce policy rates in August, even if economic recovery remains weak. At the same time, we do not expect it to raise rates immediately, as global inflation and interest rates continue to stay low.

The author is chief economist & general manager with Bank of Baroda


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