Battle against prices still on

RBI should hold on to rates as upside risks to inflation persist

The pressure on the Reserve Bank of India (RBI) to cut rates has increased substantially over the last few days, especially since factory output growth almost came to a grinding halt in April. The recent rally in the equity markets seemed to have factored in a 50 basis points cut in the repo rate. The case for a rate cut would have been strengthened if both core and headline inflation numbers had come in lower than the April print. But, this is not the case.

While the headline rate has come in at 7.5 per cent (7.2 per cent in April), core inflation, the determining number for policy action, has stayed flat at 4.8 per cent (4.9 per cent in April). But, a 10 basis points fall is not substantial enough to merit a rate cut, claim economists. Worryingly, primary food inflation, at 10.7 per cent in May compared to 10.5 per cent in April, remains in double digits. Though fuel inflation rose to 11.5 per cent, mostly on a weaker rupee, economists believe the full impact of the recent petrol price hike is not yet reflected in the headline print.

Economists have unanimously voted against a rate cut at this point, as upside risks to inflation still remain. While corporate India and market participants are desperate for a rate cut, economists are hoping the central bank would choose the path of macro prudence, as its key mandate is not to promote growth. Also, this slowdown has been engineered and, therefore, cutting rates prematurely would lead to further imbalances. There are four key reasons why the RBI should not cut rates at this point. First, the battle against inflation has not been won yet and food prices are still rising. This may worsen if the monsoon is below expectations. Second, a weaker rupee would offset the benefits accruing from the falling commodity prices. The pass-through of a weaker rupee would be felt in the coming months. Additionally, if the government chooses to increase the prices of diesel, LPG and kerosene, it would have an additional impact on inflation.

Taimur Baig and Kaushik Das of Deutsche Bank are of the opinion that while RBI should not cut rates, it probably would do so under pressure. Dhananjay Sinha, strategist at Emkay Global expects inflation to average at 6.4 per cent in FY13. However, the first half would see upside risks to inflation and it may even touch eight per cent before coming down. Even if there are aggressive rate cuts at this point, transmission would be difficult due to the liquidity crunch. Given the uncertain global macro situation, Indranil Pan, chief economist at Kotak Mahindra Bank, believes the RBI needs to hold on to its ammunition to the maximum to react to any possible Lehman-like situation. “Thus, from the growth perspective, monetary policy should now be seen as complimenting fiscal policy rather than compensating for it.”