Central bank likely to leave policy rates unchanged in April

Inflation trends appear encouraging, and that rules out another rate rise. But there are too many uncertainties & negative risks visible in the near future

Recent inflation data suggest the economy might finally be turning the corner. Manufacturing data also suggest that things are improving. The impact on monetary policy could be interesting. The Reserve Bank of India's next policy review on April 1 will be based on these data.

The retail inflation rate as measured by the Consumer Price Index (CPI) dropped to 8.1 per cent on a year-on-year (YoY) basis this February, compared to February 2013. This was the third month of a falling rate of change in CPI and 8.1 per cent is a 25-month low.

The Wholesale Price Index (WPI) was up 4.7 per cent YoY in February, which means the wholesale inflation rate has also dropped below the psychological level of five per cent. However, core WPI inflation (WPI minus food and fuel) was up slightly, at 3.15 per cent in February versus 3 per cent in January. In addition, the Index of Industrial Production (IIP) was positive, albeit barely so, at 0.1 per cent in January 2014 versus January 2013. This was the first positive IIP reading in four months.

RBI announced in January that it proposed targeting CPI and pulling it below eight per cent by January 2015 and below six per cent by January 2016. Going beyond 2016, the RBI would adopt a four per cent CPI target with a band of plus/minus two per cent. The CPI data indicate that the central bank is close to achieving its first target of eight per cent, well ahead of schedule.

RBI will presumably take many variables into account in its April policy. One key factor would be the presumed direction of food prices. This has been responsible for driving up WPI and CPI and also for the big differential between the two, since CPI has a much larger weight for food.

Usually, vegetable prices drop in winter and that has occurred. However, vegetable prices tend to rise in summer. There are also predictions of a weak monsoon this year, which could mean poor harvests. A spike in food prices in April-May could push inflation back up. A second factor to consider would be weak but positive industrial output data. A rate cut could energise IIP and encourage consumption demand. But of course, rate cuts may also trigger rising inflation.

Another factor to be considered is trends in the foreign exchange market, and global crude oil prices. A strong rupee reduces domestic inflation and eases crude oil imports. However, it also retards exports and encourages "unnecessary" imports. A weak rupee helps exports and thus, helps with the current account deficit. But it could also fuel domestic inflation, since it makes crude oil more expensive in rupee terms.

The central bank must find a happy balance and keep the rupee in the right range. This involves setting the right policy interest rates and also making correct guesses about the direction of the dollar and, to a smaller extent, the euro. The US economy is recovering and the Federal Reserve is highly likely to accelerate the pace of stimulus tapering. The dollar could strengthen as a result.

Finally, RBI cannot ignore political realities. The general election will push tonnes of cash into the economy. Much of this will be unaccounted money but it will have some inflationary effect. Election results would also impact the dollar-rupee rate, one way or another. If the market likes the results and foreign institutional investors and foreign direct investment flows increase, the rupee will tend to strengthen. If the market is dismayed and foreign investors pull out of India, the rupee will weaken.

Balancing it all, I would agree with the consensus opinion that RBI is likely to leave rates unchanged in April. The inflation trends appear encouraging, and that rules out another rate hike at this juncture. But there are far too many uncertainties and negative risks visible in the near future. I don't think RBI will chance a rate cut until there is clarity on the political front. That could happen only by late May.