The central bank will walk the talk: Radhika Rao

The Reserve Bank of India (RBI) governor's hawkish rhetoric has fed into rate rise expectations for December. And, the data concur. An uptick in Consumer Price Index-based inflation in November might have allowed the central bank to demur at this month's policy meeting.

But the sharp jump points to stubbornly high inflation, despite a negative output gap. Not acting would dilute the central bank's hitherto strong stance and risk its credibility. Therefore, we expect another 25-basis-point rate rise at the coming review.

Against this backdrop, the US Fed's decision on December 17-18 will also be of interest. Indian policymakers' move to build defences during the recent period of improved risk appetite, following the Fed's decision not to taper in September, was both prudent and opportunistic. It should help markets weather an eventual cutback in US asset purchases, even if some hit is unavoidable.

Further, an RBI committee's report on the monetary policy framework is the other big factor to watch. In the past, the central bank has faced criticism for trying to do too many things, often with conflicting objectives.

In contrast, Governor Rajan has shown a preference for a single objective, that is, 'low and stable inflation'. Nor does he see a long-term trade-off between inflation and growth. Hence, the likelihood of a calibrated and gradual shift to some form of an inflation-targeting regime is high. An immediate move, however, is hamstrung by significant fiscal deficits. Despite the fiscal responsibility Act, adherence to targets has not been taken seriously, with the exception of the last financial year.

Assuming the government undertakes remedial action to meet fiscal targets this year, the axe would fall on capital and productive expenditure. This would further hinder the built-up capacity and widen the demand-supply mismatch with clear implications for inflation down the road.

At the same time, rural wages have been boosted by government employment and income-generation schemes. In short, RBI has to keep a tight leash on the monetary policy to lean against fiscal laxity, among other price factors. Looking ahead, hopes are pinned on a stable and credible government to taking office after the May 2014 elections.

Radhika Rao
Economist, DBS Bank, Singapore