RBI policy: A wait & watch approach

Risks on account of the monsoon may have been mitigated, though not entirely dispelled, says RBI

In what was probably a foregone conclusion, the central bank has left the key policy repo rate unchanged. In its monetary policy statement, the Reserve Bank of India (RBI) reaffirmed its commitment to fighting inflation. The benchmark rate remains at eight per cent, while the statutory liquidity ratio has been reduced by 50 basis points from 22.5 per cent to 22.0 per cent

In the statement, RBI attributes the moderation in Consumer Price Index (CPI)-based headline inflation, despite the “seasonal firming up of fruits and vegetable prices”, to both the base effect and the steady deceleration in CPI core inflation that excludes food and fuel. Although, the recent CPI data does indicate that inflation will trend below RBI’s target of eight per cent by January 2015, the tone of the policy was measured. Government policy actions to contain inflation in the form of lower hikes in minimum support prices (MSPs), the decision to release food grains and to create alternate mandis are likely to moderate inflation. However, risks remain.

The monetary policy review, while indicating that achieving the inflation target of eight per cent in early 2015 is likely, elaborates on the uncertainty lurking on the horizon. With normal rainfall expected in August, one could argue that risks on account of a deficient monsoon may have been mitigated, however, they haven’t entirely dispelled. The other uncertainty, centers on the possibility of higher oil prices. Oil prices could spike up in the short term on account of disruptions in West Asia. Further, while the HSBC Manufacturing Purchasing Managers Index (PMI) report did suggest rising input price pressures and marginal rises in output prices across all sub-sectors, the services PMI data showed that “input costs rose at a slower rate in July and that firms were able to pass on a slightly bigger portion to customers by raising prices”. Thus whether the slowdown in inflation is transitory or permanent remains unclear, leading RBI to adopt a wait and watch approach.

On the issue of a revival in growth, the recent data on key economic parameters points towards signs of an incipient recovery. The Index of Industrial Production has risen on the back of a revival of the manufacturing sector. The index of eight core industries has also recorded fastest growth recorded since October 2013, growing at 7.3 per cent in June. Further, the HSBC’s Manufacturing PMI has also climbed to a 17 month high of 53 in July signaling improvement in the business environment. However, the HSBC Services Purchasing Managers' Index (PMI), fell to 52.2 in July from June's 17-month high of 54.4.

The RBI statement, reflecting these mixed signals, is cautiously optimistic stating that the “prospects for reinvigoration of growth have improved modestly”. Pointing to the role of the government in reviving growth the central banks indicates that in the event of a revival of the investment cycle along with greater fiscal consolidation, coupled with external demand picking up and stable crude oil prices, real GDP growth of 5.5 per cent can be sustained.

Interestingly, the statement does signal that RBI will be keeping a close watch on the global economic scenario, especially the actions of the US Federal Reserve. With the Fed expected to wind down its QE programme, the post taper world is likely to be unpredictable. With strong GDP and job numbers in the US, there is a high probability of the Fed recalibrating its monetary policy, with a rate hike expected early next year. A rise in the interest rates will reduce the interest rate differential and is likely to impact flows. Thus, while foreign institutional investor flows have been strong, going forward the Feds policy will have significant implications for global capital flows, especially those to emerging markets such as India.