RBI to pause, but not abandon caution

Inflation softened in December 2013, but the Reserve Bank of India (RBI) is unlikely to abandon caution as yet. The recent moderation in vegetable prices was positive, which, along with a stable currency and controlled commodity-price movements, signals manageable imported price risks. Not surprisingly, markets are primed for a rate-hold decision at the late-January review and they will not be disappointed. With a majority of RBI's pre-conditions fulfilled, the central bank has little justification to hike rates on January 28. Nevertheless, the policy commentary will carry hawkish undertones and stress that a serious view is being taken on anchoring inflationary expectations. Risks to the growth outlook will be acknowledged, but price stability will still be prioritised.

On the policy outlook, we no longer expect a 25-basis point increase in the March quarter. Instead, the benchmark rate is expected to be held steady into the next financial year (FY14). That said, the bias will still be to tighten rates if the recent drop in inflation proves transitory.

The doves will, however, be disappointed if they expect RBI to shift to an accommodative policy gear anytime soon. The recent downtrend in prices is comforting, but it is still premature to assume inflation will fall in a straight line. There are several factors that warrant attention. Firstly, policymakers need to ascertain the easing price trends sustain over the next few months and a notable impact is felt in the inflationary expectations survey. Secondly, even as urban spending is weighed by a weak industrial sector and high borrowing costs, rural demand has displayed strength on the back of recovery in the agricultural sector.

Next, the pullback in December price pressures was not uniform and heavily concentrated in the primary articles index. The manufacturing and fuel gauges flatlined, while the core wholesale price index ticked up. Finally, concerns over marked revisions in backdated data remain. In this regard, December's provisional release might have overstated the pace of the pullback. To sum it up, an ahead-of-the-curve cut could dilute the anti-inflationary stance of the central bank, thus warranting an extension of the pause-and-watch stance over the next few months.

Radhika Rao

Economist, DBS Bank