The Reserve Bank of India (RBI) was itchier to cut policy rates than expected, but the 50-basis point cut may have been a bit too premature and aggressive, in our view. If the upside risk to inflation materialises, it could hurt RBI’s credibility and leave the cuts doing little to raise growth on a sustained basis.
The aggressive move was surprising considering the fundamentals have not changed materially since the last monetary policy meeting in March. In fact, global and domestic economic conditions remain broadly the same, in our view, while inflation risks have increased on the back of high oil prices and depreciation of the exchange rate. Yes, the Budget has been delivered, but the planned tightening is not sufficient to change the course of monetary policy, especially when you consider the likely fiscal slippage.
The assessment of core inflation in Tuesday’s statement came across as potentially a bit too sanguine, in our view. While the annual core inflation has eased, it does not just reflect the lagged effects of monetary policy tightening but also the high base in February-March last year. When this base effect washes out, core inflation could increase over the next few months. In addition, PMI indicators of backlogs of work and supplier delivery times suggest capacity remains tight and there is very little slack in the economy. This could make it difficult to keep March-2013 WPI inflation contained at 6.5 per cent as RBI expects; our forecast is 7.1 per cent.
Looking ahead, there is limited room to cut rates further, especially following Tuesday’s deep cut. The constraining factors we see are broadly similar to those noted by RBI: (i) the combination of the depreciated exchange rate and high oil prices present upside risks to broader inflation pressures; (ii) the fiscal stance may not prove sufficiently tight and progress on supply-side reforms may prove too slow; and (iii) the wide trade deficit prevents RBI from boosting domestic demand too much.
Leif Eskesen, Chief Economist, India & Asean, HSBC Global Research