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Inflation trumps growth

Sonal Varma 

Improving global growth prospects, strong domestic expansion and rising prices suggest inflation will trump growth as the key policy concern in the Reserve Bank of India’s (RBI’s) third quarter review of the monetary policy on January 25.

Sonal VarmaInflation is likely to remain at elevated levels. The sharp rise in prices of vegetables may reverse, but the same is unlikely to happen with other food items unless there is a supply-side response, which will take time. Surveys show that households’ inflation expectations have been rising and may result in wage inflation. Rising input costs have led to margin pressure for firms and they may pass on some of this to consumers. Billowing fuel subsidies mean a rise in domestic fuel prices is pending. Therefore, we expect RBI to revise its wholesale price index (WPI)-based inflation projection for March from the earlier 5.5 per cent to 6.5 per cent.

Growth prospects for the developed world look brighter, led mainly by the US. Domestically, industrial output data have been weak, but, given the volatility in this series, RBI is likely to focus on a broader set of indicators. Both manufacturing and services PMIs (purchasing managers index) continue to remain comfortably above the expansion threshold of 50. Exports have maintained their sequential uptick since August. In our view, the lagged effect of policy tightening will slow real GDP growth in FY12, but we expect RBI to focus on the broad-based nature of the current expansion and the growing private demand. RBI could upwardly revise its real GDP growth projection of 8.5 per cent for FY11.

The re-emergence of inflationary pressures amid still-strong growth suggests inflation will remain RBI’s top priority. Inflation is partly due to structural bottlenecks, which require a supply-side response. However, with no long-term plans to resolve these constraints and food price inflation a political hot potato, RBI will have its work cut out as far as fighting inflation is concerned. Having already raised repo rates by 150 basis points (bps) and reverse repo rates by 200 basis points in 2010, we expect it to raise rates by another 25 bps on January 25, maintaining a hawkish bias and leaving the door open for further increases.

The writer India Economist, Nomura Financial Advisory and Securities (India) Pvt Ltd

First Published: Thu, January 20 2011. 00:00 IST