July policy a close call rate cuts to follow

Rate cut expectations in July have softened recently, with strong anti-inflationary rhetoric from the Reserve Bank of India (RBI). It will, however, be difficult for RBI to deny further monetary easing for long, in my opinion, given aggravating growth concerns. Headline inflation will stay stubborn for a while, with possible upsides from fuel and food prices.

Core inflation, however, will likely soften further in the coming months, with weakening demand. The spillover of higher fuel and food inflation, unless dramatic, on core inflation will likely be limited, given poor industrial demand and weaker pricing power. Near-zero fiscal headroom, and likely limited government policy initiatives will eventually put further pressure on RBI to support growth.

While the timing of further monetary easing remains uncertain, I expect cumulatively 150-basis points (bps) of rate cuts during 2012-13 (including 50 basis points delivered in April). RBI action next week remains a very close call; I maintain a bias for a 25-bp cut in the repo rate. Importantly, the government’s ability to marshal a fuel price rise in the near term remains a key event, as that would be seen as the first initiative (even if token) to tighten the fiscal belt.

The near-term policy uncertainty gets intensified with the truant monsoon. The risk of higher inflation due to sub-par rains remains unmistakable, which can push rate cuts back. Nevertheless, with weak exports and investments, consumption remains the key for growth in 2012-13 and a bad monsoon can hurt consumption far worse than on earlier occasions. For example, the monsoon was poor in 2009-10. But monetary policy was far easier, global growth was stronger, commodity prices were lower and overall business sentiment considerably better.

More, the government could provide sizeable fiscal support (for example, rural employment support, higher support prices for crops, salary rises in the government sector, cuts in excise and service tax rates), which would likely remain absent this year. Future guidance on monetary policy would be as important as the rate action in July. Recently, RBI kept moving the focus on inflation indicators (headline, core, CPI, core-CPI).

Trends in these measures have often been divergent, leading to higher policy uncertainty. It is important that the central bank brings back policy focus more on just one or two of such indicators, considerably enhancing consistency and credibility of monetary policy.

 

The author is chief India economist, Barclays