Facebook Pixel Code

Column: Surprisingly, RBI stays on hold

The central bank may be on hold for now, but don?t rule out more aggressive action later

India?s central bank surprisingly stayed on hold indicating that the ?policy decision was a close one? but arguing that the recent surge in inflation (CPI at 11.2% and WPI at 7.5%) was mainly on account of food prices, and there is evidence that vegetable prices had moderated sharply in December, and therefore it would like to see another round of data before making a decision on policy rates.

The policy statement admitted that inflation was unacceptably high but pointed to the prevailing uncertainty at the future path of inflation, noting, ?Current inflation is too high. However, given the wide bands of uncertainty surrounding the short-term path of inflation from its high current levels, and given the weak state of the economy, the inadvisability of overly reactive policy action, as well as the long lags with which monetary policy works, there is merit in waiting for more data to reduce uncertainty.?

The decision came as a surprise to markets that were bracing for a hike. To be sure, it?s perfectly understandable?and desirable?from the central bank to see through temporary supply shocks. Vegetable prices have undoubtedly moderated sharply in the month of December and that is expected to pull down both headline CPI and WPI next month.

But our belief that RBI would raise rates at this review was based on several other factors: (a) that, despite the sharp expected moderation in vegetable prices in December (with December CPI expected to dip below 10%), CPI inflation remains on course, to stay well above the 9% levels till March that RBI had forecast at the last review; (b) that, even without vegetables, the quarterly, annualised momentum of headline WPI (quarterly, annualised) is running about 10%?so inflation pressures are more broad-based than vegetables, (c) that non-food inflation pressures remain elevated: core CPI inflation has remained close to or above 8% for the last five months, and the annualised quarterly momentum of WPI core inflation is above 6% for the last three months, (d) that not doing anything at this review ran the risk of causing already-elevated inflation expectations from getting further entrenched, and (d) that, with rural wages re-accelerating, input price pressures still strong, the persistence of food shocks runs the risk of getting more generalised.

All these factors were acknowledged in a hawkish policy statement by RBI. Specifically, the statement argued that ?high inflation at both the wholesale and retail level risks entrenching expectations at unacceptably elevated levels, posing a threat to growth and financial stability. There are also signs of a resumption of high rural wage growth suggesting second round effects cannot be ignored. High and persistent inflation also increases the risks of exchange rate instability.? Given this, the policy action of waiting for another round of data releases came as a bit of a surprise, especially because food prices are so volatile, that any moderation in December could easily be reversed in January, for example. Analysts have repeatedly pointed to food shocks being temporary. But even as each shock has been temporary (by definition), the persistence of these shocks has meant permanently high food inflation, averaging 11.5% over the last 7 years?and precipitating a more generalised inflation. Those dynamics are unlikely to change soon, and therefore we remain less sanguine

on the trajectory of food

inflation after the anticipated decline in December and January.

Equity markets celebrated the central bank staying on hold. But they would do well to carefully read RBI?s guidance which was very hawkish. The central bank indicated that ?if the expected softening of food inflation does not materialise and translate into a significant reduction in headline inflation in the next round of data releases, or if inflation excluding food and fuel does not fall, the Reserve Bank will act, including on off-policy dates if warranted? It further indicated that ?policy action on those dates will be appropriately calibrated? implying that the consequence of staying on hold now could be more aggressive action later.

So, what does this suggest for further rate action? As alluded to above, recent wholesale and retail price data does reveal that vegetables prices have corrected almost 25% in the month of December. Consequently, December CPI inflation could print in the 9.5-9.7 % range and December WPI in the 6.8-7% range?constituting an appreciable reduction in the headline and, prima facie, satisfying one of the two criteria laid out by RBI for staying on hold further. Any rate action would therefore depend on RBI?s second criterion: a moderation in core inflation. Assuming the same sequential momentum of CPI core in December as was the case in October and November (0.5% month-on-month), December core CPI would print at the same 8% levels, and the absence of moderation from the current elevated levels, should?as per the RBI?s guidance?be enough to raise rates at the January review. But this remains a close call in light of the latest guidance and would be very data dependent.

More fundamentally, however, even as CPI and WPI moderate from the sharp moderation in vegetable prices in December, our current forecast calls for the CPI to gradually re-accelerate thereafter towards 10% by March. Similarly, while the WPI benefits from large and favourable base effects in January and February, our forecast calls for it to be back above 7% by March 2014, suggesting monetary policy will need to remain tight for the foreseeable future.

Markets may be celebrating RBI staying on hold for now. But what is needed is sober introspection on why non-food inflation still remains relatively high even as growth impulses remain so weak. Why is core CPI at 8% if growth is at 4%? The sobering reality is that these can only be reconciled by accepting that?in a world where almost all countries have seen a sharp markdown in potential growth?India may be no different. Potential growth is likely much lower in India than is presumed. So, the government?s focus must be on easing supply constraints and RBI?s focus must be on anchoring inflation expectations. That?s the only route to escaping the stagflationary trap that India is stuck in.

Sajjid Z Chinoy

The author is senior South Asia economist at JP Morgan

Get live Share Market updates, Stock Market Quotes, and the latest India News and business news on Financial Express. Download the Financial Express App for the latest finance news.

First published on: 19-12-2013 at 02:35 IST
Market Data
Market Data
Today’s Most Popular Stories ×