Growth at around 8% would keep excess demand in place for too long, leaving inflation elevated for long.
The RBI raised the policy (repo) rate by 25 bps as expected and the statement remained hawkish. While voicing more concern about the global economic backdrop and seeing downside risks to domestic growth, RBI still sees upside risks to inflation and, therefore, decided to keep the tightening bias. However, further moves were conditioned also on global developments. We expect at least another 25 bps, possibly as soon as Q4 this calendar year.
Facts
The RBI hiked the policy rate (the repurchase or repo rate) by 25 bps to 8.25%, in line with our call and consensus. Consequently, the reverse repo and marginal standing facility rates were automatically adjusted by 25 bps to 7.25% and 9.25%, respectively. The cash reserve ratio (CRR) was kept unchanged at 6%.
On the global backdrop, the statement, not surprisingly, voiced unease, noting that ".....developments in the global economy over the past few weeks are a matter of serious concern," with the "growth momentum weakening in the advanced economies amidst heightened concerns that recovery may take longer than expected earlier."
On the domestic economy, the statement points out that "...although India's exports have performed extremely well in the recent period, this trend is unlikely to be sustained in the face of weakening global demand." The statement notes that "this, combined with the slowing down of domestic demand, to which the monetary policy stance is also contributing, suggests that risks to the growth projection [8%] for 2011-12 made in the July Review are on the downside."
Turning to inflation, the RBI is still not a happy camper. The statement refers to inflation being "high, generalized, and much above the comfort zone.." and it also highlights "continuing demand pressures" and "an element of suppressed inflation", with the latter referring to the incomplete pass-through of higher oil prices, including in terms of administered electricity prices. Moreover, the RBI is concerned about food inflation, seeing it as driven by "structural demand-supply imbalances and [something that] cannot be dismissed as a temporary phenomenon."
Fiscal policy also "earned" a separate paragraph in the statement, with the RBI understandably not happy about fighting a lonely battle against inflation with the fiscal stance at risk of being looser than planned if the government does not counter the slippage on the revenue and spending side (subsidies).
Implications
The first letter of "India" is part of the BRIC acronym, but there are many differences between these countries and economies, including when it comes to the monetary policy cycle. Compared to these countries and Asian peers, India faces a more severe inflation problem and the domestic orientation of the economy also shelter it more against adverse global economic spillovers. This is essentially why the RBI still sees inflation as the dominant concern and rightly marched on with more tightening, moving in the opposite direction from its Brazilian peer.
Overall, the statement was hawkish, as it should be. The RBI is concerned about the still elevated level of global commodity prices, which have not moved much, and it points out that there is still an element of suppressed inflation in the economy despite the recent adjustment in domestic fuel prices. Moreover, the statement voiced concerns that food inflation may not ease as much as expected. RBI is also clearly very uneasy about the generalized price pressures in the economy due to strong demand conditions, which allows for strong pass-through of rising input costs. While it sees inflation pressures easing in the latter part of FY2012 in response to the lagged effect of monetary tightening, it is clearly worried that inflation expectation will rise further as inflation remains high in coming months. This is why it considers it "imperative to persevere with the current anti-inflationary stance."
Now, RBI is, of course and rightly so, concerned about where the global economy is heading and do see an impact on growth through the trade channel. No surprise there. While they are not ready yet to revise down their 8% growth forecast for FY2012, likely reflecting the domestic orientation of the economy, they are recognizing downside risks to this forecast in light of both the global and domestic slowdown. This is likely to ultimately see them lower their forecast and bring it closer to consensus (7.5%) and our forecast of 7.4%.
However, even if they revise down growth in line with our (or the consensus) forecast this should not change the policy stance in our view. As we have argued many times before, growth in India has to slow down sufficiently below potential (81/4%) before the excess demand in the economy (output gap) will disappear and, therefore, lower demand-led inflation pressures more notably over the policy horizon. Growth at around 8% would keep excess demand in place for too long, leaving inflation elevated for long and, thereby, running the risk that inflation expectations will continue to drift upwards. Exactly what the RBI is concerned about.
Now, what can we expect going ahead? Well, since the RBI has maintained the tightening bias, further hikes are certainly on the table and we see at least another 25bps. This could come as soon as Q4 this calendar year and possibly already at the next meeting, barring any further worsening in the global economic environment and/or a better-than-expected outcome on the inflation front. While the RBI did not signal a pause, they instead, as we had expected, explicitly signalled that global economic developments would have an impact of future decisions. So, eyes remain focused on the US and Europe.
Bottom line: The RBI still rightly sees inflation as the dominant concern for India's domestically oriented economy and maintained the tightening bias, signalling that further hikes are likely. However, further moves are now more explicitly conditioned on global developments.
Source:- IIFL PReMIA
