Fog lifts but the puzzle continues

In the current scenario, is there a case for RBI to lower policy rates? Not much, as the core CPI still remains elevated around 7.9% versus 8.0% in November 13

India faces the risk of stagflation, given the continued contraction of its industrial sector, high CPI-based inflation and resulting high interest rates threatening to derail its economic model geared towards enhancing consumption. While stimulating consumption and creating more inflationary pressures had remained the dominant fiscal theme since 2008-09, there is a constant pressure on the Reserve Bank of India (RBI) to encourage investments by slashing policy rates despite sticky inflation and elevated inflationary expectations.

With a fall in the headline Consumer Price Index (CPI)-based inflation from 11.2 per cent to 8.1 per cent in three months, the industry has been urging RBI to cut interest rates to spur investment, even when it knows that a confluence of factors like poor infrastructure and energy access, delays in bureaucratic processes, stifling labour laws and election-related policy uncertainty are the factors behind the slowdown in investment.

In the current scenario, is there a case for RBI to lower policy rates? Not much, as the core CPI still remains elevated around 7.9 per cent versus 8.0 per cent in November 13. Moreover, we expect the CPI-based inflation to start increasing again soon on account of significant damage to foodgrain and perishables due to unseasonal winter rains and hailstorms in the country and continued increase of 15 per cent (y-o-y) in rural wages and populist spending. There is also a threat of the El Nino phenomenon in 2014, which could result in lower rainfall in 2014. These factors have certainly created an upside risk to CPI, which the RBI cannot ignore at this stage. Even if it lowers the policy rate, there will be limited transmission to the lending rates, as the deposits' cost continues to remain elevated for banks due to high retail inflation. Moreover, the government has increased interest rates on competing products like postal deposits and PPF ahead of the polls, making it all the more difficult for banks to reduce deposit rates and create a room for lending rate reduction.

In the current circumstances, RBI has no option but to stay on hold at the April policy meeting. But its forward guidance will be instrumental in setting the future interest rate direction.

The writer is chief economist & general manager at Bank of Baroda