A hike for sure?

The recent behaviour of macroeconomic indicators have apparently convinced financial markets that the Reserve Bank of India (RBI) will hike the benchmark repo and reverse repo rates in its next policy announcement, scheduled for October 31. GDP growth during the first quarter of 2006-07 surprised everyone by clocking 8.9 per cent. Industrial production numbers for July and August do not suggest any let-up in the momentum; so it would be reasonable to expect that the economy will grow in excess of 8 per cent during the second quarter as well. In view of the fact that the RBI's growth estimate for 2006-07 as a whole is currently in the band of 7.5-8 per cent, the current pace can only be seen as posing a serious danger of overheating, which means that accelerating inflation cannot be far behind. This fear will clearly be reinforced by last week's announcement on the movements in the Wholesale Price Index (WPI), which showed that the inflation rate had crossed the 5 per cent mark after remaining below it for 4 weeks in a row. Although the RBI's inflation forecast for the year is in the 5-5.5 per cent band, any signs of acceleration are bound to be viewed with some concern. Both growth and inflation moving in the same direction is symptomatic of overheating and the textbook would suggest hiking rates.

However, there are several factors worth considering and they suggest otherwise. One, it is now quite clear that the US Federal Reserve has come to the end of its rate hike cycle. The next change, when it comes, is more likely to be a reduction than an increase. It appears that the series of hikes in the federal funds rate, its primary instrument, has had the desired effect; while inflation is under control, growth is becoming a little sluggish, suggesting an end to the hikes. The Bank of Japan has followed suit. The European Central Bank did raise its rate recently, but then, it, along with the Bank of England, practises inflation targeting, which is a commitment to keeping inflation below a certain ceiling, regardless of what this may do to growth. One would expect central banks that follow this approach to be a little more trigger-happy with interest rates. Two, oil prices appear to be moving downwards with some degree of predictability, driven obviously by an anticipated slowing of growth in the US and uncertainty about what OPEC will achieve by way of a production cut. A US slowdown certainly presages global moderation of all commodity prices, reinforced by the impact of slowing exports to the US from the Asian economies. All this suggests that, whatever else may be happening in the domestic economy, the threat of inflation will significantly decline over the coming months.

So, what is the RBI going to do? Recent pronouncements and actions suggest that it will opt for discretion and give more weight to domestic factors, which suggest overheating, and less to global ones, which suggest moderation. In short, a hike is the likely announcement on October 31. However, it should, in the process, keep in mind that its current growth outlook for the year is underestimated and communicate to the markets an updated view of the sustainable growth-inflation combination for the economy. The extent of overheating will not seem so significant then.