After a gap of four months and three policy review meetings, the RBI got a chance to maintain status quo. Having recognised that weak growth conditions provide limited headroom for hiking policy rate, hereon, the RBI judiciously decided to ‘wait out’, relying on a sensible mix of plausible manifestation of forward-looking forces, coupled with lagged impact of previous rate actions.
Recall, rate expectations in the run up to the policy were fanned by an unanticipated spike in both wholesale and retail inflation on the back of a sharp rise in vegetable prices. Despite a good monsoon and restrained increase in minimum support prices this year, annualised food inflation running at the rate of ~14% is ironical.
This raises second order risks of contagion. More importantly, it will also have an adverse impact on household inflation expectations, which are already weighed down by the ongoing fiscal pass-through in fuel prices. As per our estimates, inflation in food, fuel, gold, and textiles (having a cumulative weight of 48.7% in the WPI) show a reasonably strong correlation of 78% with household inflation expectations.
A rate hike under these circumstances would have been easy to justify. However the status quo, by no means, must be construed as a dovish signal. The RBI has clearly articulated its readiness to act promptly, if and when warranted.
Among the forward looking forces, in addition to the disinflationary impact of the recent exchange rate stability along with continued slack in the economy, anecdotal evidence so far suggests a sharp correction in vegetable prices since the last week of November. This should get reflected in the December inflation print. Having said so, the impact of overall food inflation could be partially diluted due to:
Rise in sequential price pressures (based on partial information on daily prices for certain commodities) observed for certain food
items like rice, wheat, pulses, and milk; A possible increase in trading mark-ups by intermediaries which could potentially impede the full pass-through.
Moreover, the core inflation trajectory is unlikely to provide much comfort to RBI. Core CPI inflation is likely to be sticky downwards with little room for correction.
On the other hand, core WPI inflation is expected to rise towards 3.0-3.5%, with adverse base effect playing a key role in Q4 FY14 from 2.63% currently. Any less than desirable reduction in inflation pressures, will risk aggravating second round impact and unhinging household expectations. In such a scenario,