There is something uncanny about the timing of the 50-basis point (bp) rate increases by the Reserve Bank of India (RBI). The two 50-bp hikes in June-July 2008 came slightly before the global financial meltdown, which was triggered by the Lehman bust in September that year. This year, the first 50-bp rate hike took place after global commodities had already hit an air pocket. The second, and latest, 50-bp hike in July came less than a month before the recent rout in global financial markets, partly triggered by the renewed weakness in the US economy and its sovereign credit downgrade.
Overall, the ongoing global financial mayhem creates a strong deflationary environment that will not spare India. Is RBI missing something since its recent increased hawkishness and aggressiveness have come about despite a worsening global backdrop? Equally importantly, is it underestimating the pace of the economic slowdown?
On July 26, RBI unexpectedly raised the repo rate by 50 bps, against the widely anticipated 25 bps, and also raised its wholesale price index (WPI)-based inflation forecast for March 2012 to seven per cent from six per cent announced in early May. It left its gross domestic product (GDP) growth forecast of eight per cent for FY12 unchanged. What is it that RBI knows about the growth dynamics that everyone else is missing, and what are the contours of these hidden insights that allow RBI to be more optimistic than market expectations? Strangely, relative to market expectations, RBI’s forecast for GDP growth is above consensus while its inflation forecast is below consensus.
The central bank has acknowledged that there is a moderation in growth but that it is neither sharp nor broad-based. Now, consumption that is sensitive to interest rates is already slowing meaningfully, while investment activity has been weak and higher rates don’t augur well for its outlook. A sizeable portion of consumption not sensitive to interest rates has favourable structural drivers and has also been positively affected by government policies (for example, higher minimum support prices) that monetary tightening cannot effectively check. Fiscal measures will be more helpful but these remain uneven and uncertain at best. Overall, just as the recovery following the global credit crisis was uneven, the moderation too is uneven.
The one area where RBI has failed to provide more meaningful insight is the exceptionally strong export data in recent months, despite weaker global environment. It has concluded that these signal still-strong activity in the export sector. However, it is possible that there has been a significant rundown of inventories (perhaps owing to concerns over the end of export incentives), which, in turn, has temporarily boosted the reported export growth. Once this aspect is taken into account, the moderation in economic activity is more pronounced than what RBI is indicating. The weakening global backdrop will also hurt exports. The bottom line is that RBI will soon be forced to cut its GDP growth forecast.
What prompted RBI to raise its inflation forecast of six per cent, which, in the first place, only RBI believed in? In early May, the central bank had guided that WPI inflation in the first half of the current fiscal year would remain elevated at around the March level. RBI had also communicated that the assessment included the impact of an undisclosed increase in local fuel prices.
Now, the final reading for March WPI inflation was 9.7 per cent year-on-year (YoY), while average inflation in April-June was 9.4 per cent, which will probably be slightly above 10 per cent following the revisions. If realised, that outcome would not be too out of line to have been the only factor for RBI to raise its March 2012 WPI inflation forecast so soon. Is it perhaps explicitly assuming further adjustments in local fuel and/or electricity prices in its revised forecast trajectory? If so, why has it not categorically stated it? To be sure, RBI has only indicated risk of such adjustments given suppressed inflation in India — not that these adjustments are now assumed in its WPI forecast trajectory.
A few days ago, RBI Governor D Subbarao indicated that there is no new higher normal for inflation. Frankly, central banks will rarely admit to a new higher normal for inflation. With due respect to the governor, it is hard to buy his conclusion, especially since RBI has been revising its inflation guidance upwards in the last few years and again in the July policy. If there is no new higher normal for inflation, why is RBI unable to avoid raising its inflation forecasts repeatedly?
The most puzzling – and unquestioned – aspect of the July policy statement was the absence of a categorical mention of the risk to growth and inflation from adverse global developments, a point that was emphatically mentioned in the May policy statement. Perhaps RBI had to downplay it to justify the 50-bp rate hike. As subsequent global events have shown, that shift in focus away from global factors was ill-timed and irresponsible.
The hit to India’s growth will be less pronounced but the ongoing correction in the prices of global commodity, especially crude oil, and the broader global deflationary force will be positive for India’s pesky inflation. Hopefully, RBI has learnt from the 2008 experience and will react quickly this time. Remember that even in the October 2008 policy review, RBI was fighting inflation while the world was experiencing an unprecedented deflationary shock.
The current global backdrop is different from what emerged in 2008 and the deflationary shock may be less severe. However, financial and macroeconomic stability should now become more important for RBI. Ironically, it is lower global commodity prices that will be positive for fighting inflation rather than the aggressive rate hikes by RBI. It remains unclear how global events will precisely unfold, but it will be sensible for RBI to signal a wait-and-see approach in the near term for its monetary policy, especially since the global commodity rout offers some breathing room. Hopefully, the RBI will rise to the occasion in a timely manner.
The author is senior economist at CLSA, Singapore
The views expressed are personal
