RBI set to enter a 'wait and watch' phase

The Reserve Bank of India (RBI) has a tough task ahead on October 25, when it announces its monetary policy for the second half of this financial year. On one side are industry bosses and consumers, who are keenly looking up to RBI and hoping it does not signal more increases to their borrowing costs. On the other side are inflation hawks, who would still want to see tightening by RBI, irrespective of the growth dynamics.

We think RBI should be looking to press the pause button now, a view that I had held from September 16. To reiterate, in the September policy, RBI had indicated its future stance on monetary policy would be influenced by “signs of downward movement in the inflation trajectory”. At that time, RBI also expected the impact of its past policy actions “should now be increasingly felt in further moderation in demand”, and, in turn, reverse the inflation trajectory in the later part of FY12.

Some definitive signs of a slowdown have also emerged now. Manufacturing PMI had been consistently dropping from April, but the more pertinent issue is it is now close to the contraction zone, tending to tip below 50. The services PMI is already below 50, indicating a contraction in this segment. Further, some lead indicators for growth such as excise collections have tended to show a very sharp contraction, while earnings growth for the Bombay Stock Exchange-30 companies (ex-energy) is also expected to be lower in the second quarter, compared to the first. Anyway, the slowdown story in segments such as that of passenger cars, is well known.

The history of past policy tightening by RBI suggests it has tended to pause after inflation peaked out. In September, headline WPI inflation stood at 9.72 per cent, down from the previous month, while the more relevant non-food manufactured products inflation is now down to 7.62 per cent from 7.74 per cent in the previous month. There also appears to be a close correlation between PMI manufacturing and non-food manufactured inflation, lagged by six months. This should suggest to RBI that the impact of the past rate rises are percolating into the economy.

However, the suggestion of a pause in the current rate rise cycle in no way indicates RBI would be changing its monetary policy stance soon. The fight against inflation is likely to be intact, and the rhetoric of RBI on inflation would continue to stay hawkish. The stance is unlikely to change, unless there is a significant drop in headline inflation numbers, which could be much later.

If all goes well, and global commodity prices do not surprise on the higher side in the interim, I would expect headline WPI inflation to stand at 5.5-6.0 per cent in the second quarter of the next financial year. Hence, till then, RBI should be seen holding on to its tight monetary policy stance.

The writer is chief economist, Kotak Mahindra Bank Ltd