An uncharacteristic move

COMMENT: Jahangir Aziz, India Chief Economist, JP Morgan

After a 25-bps rate hike by the Reserve Bank of India (RBI), equity and bond markets heaved a sigh of relief, as their fears of an aggressive tightening did not materialise. But, this relief rally may be short-lived. By not acting aggressively now, RBI has only raised the likelihood of an inter-meeting rate hike, and that of being forced to tighten too much, if inflation breaches its tolerance level.

What was more disconcerting was the uncharacteristically confusing and inconsistent policy statement. Uncharacteristic, because RBI had begun to instill clarity and plainspeak in its communications over the last year. It expects growth in FY11 to reach 8 per cent. It expects inflation to stabilise at the current 10 per cent level and then decline to 5.5 per cent by end-March.

But, it admitted that both its growth and inflation projections had upside risks. Inflation, in particular, could see upward pressures from the return of corporate pricing power, elevated global input prices and strained domestic capacity, as growth broadened and accelerated. In fact, on inflation, RBI did not mention a single mitigating risk. True, the investment cycle has not revived. True, credit growth is still languishing. But, monetary policy is forward looking. Peering into the crystal ball, RBI sees the balance of risks to be almost all on the upside, so “calibrating” policy surely should imply a more aggressive stance than the one which keeps policy rates still several hundred basis points below what prevailed at the start of the last inflationary episode in mid-2008. Inflation risks may already be well-entrenched in the baseline. Headline inflation could easily breach 10 per cent soon, as the recent rise in steel and cement prices are entered into WPI. And, it is not hard to imagine inflation declining, but to a higher “normal” than 5.5 per cent as India enters into a structurally constrained phase in its growth cycle. I am guessing RBI plans to raise rates between meetings if inflation prints turn out to be higher.

What I am not sure whether this policy “calibration” curbs inflationary expectations or just reinforces that RBI is behind the curve.