Indian financial markets have been barely able to contain their excitement in recent weeks. Episodic reform efforts by the government have certainly contributed to that euphoria. But underpinning all this is the expectation that RBI will, finally, be able to start on a significant monetary easing cycle. As a result, short-end swap markets are pricing in 75-100 bps of front-loaded cuts in 2013, bond yields have rallied 30 bps over the last six weeks, and equity markets have rallied nearly 10% since October—likely pricing in the growth stimulus that such an easing cycle could generate. And why not? Don’t the current growth-inflation dynamics justify aggressive monetary easing?
To be fair, there is merit to this argument. The current growth momentum (annualised sequential growth) fell to 4% in 3Q12 and is below the most sobering estimates of potential growth. Output gaps have finally closed and, in fact, turned modestly negative in India. It’s no wonder that producer-pricing power is finally being impinged, as manifested by the monthly momentum of core wholesale prices remaining very muted for three successive months. Core inflation is, therefore, at a near three-year low. All this is true and, by itself, perhaps warrants 25-50 bps of cuts in the first quarter.
But not more. And here’s why. Think about why output gaps have closed and pricing power has abated. This has not happened because investment has picked up, capacities have come on-line and pricing power has been competed away. Not by a long shot. It’s happened primarily because demand has fallen off sharply, part design and part accident. Rural demand has been come off both because the monetary policy tightening of the last two years has slowed growth and because the monsoon and kharif crop were less than stellar last year. In addition, slowing global growth—the second and third quarters of 2012 witnessed among the slowest global growth since the expansion began in 2009—has caused India’s exports to fall off a cliff. And government spending has ground to a halt in the last four months as authorities tried to avoid runaway slippage this year. So, slowing demand has been the reason that output gaps have turned negative and inflation pressures have abated.
Now, let’s project forward. High-frequency indicators suggest growth has bottomed and a modest re-acceleration is on the cards. New export orders suggest a meaningful export pick-up in the coming months. A strong rabi crop should boost rural demand