Column: Sequencing monetary policy moves

Oct 28 2013, 03:20 IST
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SummaryNo surprise for markets if a 25bps repo rate hike comes with a 25bps cut in the MSF rate in the October review

When a central bank has to increase its inflation forecast while simultaneously reducing its growth forecast, the backdrop for a monetary policy meeting becomes complex. In its October policy meeting, the Reserve Bank of India (RBI) is likely to be faced with such a scenario—its 5.5% GDP growth forecast for FY14 is looking difficult to be achieved and the inflation trajectory has deviated upwards from the forecasted path. It is reasonable to think that RBI will be more worried about inflation as the RBI Governor, Raghuram Rajan, has indicated that there is no short-term trade-off between growth and inflation. So, markets will probably not be surprised by a 25 bps increase in the repo rate in the October policy.

Will RBI raise the repo rate by 50 bps? There are two considerations that work against aggressive tightening. One, the Governor himself has recently alluded to a large negative output gap exerting disinflationary pressures with a lag. A demand slowdown is likely keeping a check on pricing power in some sectors, particularly manufactured products. A tightening shock might become an overdose; gradualism might work better. Two, a surge in food prices has caused the recent inflation pick-up. Food inflation at 18.4% in September is at a 38-month high, unusual in a year with a normal monsoon. Interest rate hikes are not a solution to food inflation, and RBI is likely to factor in the transitory nature of this food inflation.

However, regardless of the source of inflation, RBI will still be justified in stressing inflation management. There is always a risk that high food prices spill over into a more generalised inflation problem, especially when inflation expectations are still in double-digits and consumer prices (CPI) are persistently much higher than the policy rate. RBI has been worried about the consequences of keeping real rates negative for a prolonged period. To make matters worse, even core inflation started inching up in September, breaking a one-year downtrend.

In fact, going forward, the base effect on core inflation is significantly negative (in H2-FY13, the manufacturing prices index went up only 0.5%). So, even with moderate sequential month-on-month price increases, year-on-year core inflation could increase substantially. Also, suppressed inflation in fuel prices should not be ignored. At some point the government will have to narrow the gap between domestic and international prices to safeguard the fiscal deficit target. Core CPI, though a small component of the overall CPI,

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