Stemming inflation & sequencing the exit

RBI likely to increase its March-end inflation forecast but at the same time trim down GDP growth forecast

Inflation remains the focus of the October 29 monetary policy. The comfort on Wholesale Price Index (WPI) lasted only four or five months and Consumer Price Index (CPI) is still way above an acceptable mark. It is true that food prices, particularly vegetable prices, have been the reason behind the recent increase in inflation but going forward, we see risks of even core inflation inching up. The base effect on core inflation is significantly negative (in the second half of FY13, the manufacturing prices index went up only 0.5 per cent) and suppressed inflation in fuel prices should not be ignored. We hope that food prices will decline; otherwise, headline inflation could turn ugly again.

The Reserve Bank of India (RBI) is likely to increase its March-end inflation forecast but at the same time, trim the GDP growth forecast. The classic monetary policy dilemma is back, but we think that on balance, RBI is likely to raise the repo rate by 25 basis points (bps) in the October policy to stress its anti-inflationary stance.

The good news is coming from the external sector. The balance of payments (BoP) stress is receding and the stability in the currency market has given RBI the option to gradually remove some of the extraordinary liquidity tightening measures. The sequencing of further normalisation would be another interesting element of the October monetary policy. Markets are looking for three different areas of normalisation — a) the corridor between repo rate and marginal standing facility (MSF) rate to be brought down to 100 bps; b) liquidity easing to ensure the overnight call rate switches from the MSF rate to the repo rate; and, c) oil marketing companies starting to access the markets for their dollar needs.

We think restoring the corridor to 100 bps can come in the October policy itself with a 25-bp cut in MSF rate. The other two could be more gradual processes, often occurring simultaneously. In fact, the speed at which RBI will bring in these changes will indicate its bias towards inflation and the currency. A more hawkish bias or fear of currency depreciation might delay the switch of call rate from MSF to the repo rate.