The Reserve Bank of India (RBI) delivered a surprise 50 basis points rate hike on Tuesday in a clear attempt to finally get its hands around India's increasingly ingrained inflation problems. Tuesday's aggressive move lifts the policy rate (repo rate) to 8 per cent, increasingly into territory that we would regard as restrictive, and so should quicken the nascent signs of slowdown that the economy has begun to exhibit in recent weeks.

INFLATION'S DIMENSIONS

India's inflation problem has increasingly become a two-dimensional one over the last year. A structural food inflation problem has clearly emerged in recent years, as rising incomes have fuelled shifts in diets and a rising demand for protein sources that the supply side cannot keep pace with, at least in the short run.

However, unrealistic policy settings — both monetary and especially fiscal — have seen the economy move into overheating territory over the last year, overlaying a cyclical demand-pull inflation on top of the structural food price problem. This has once again blown the RBI's inflation forecasts off-course. Inevitably, the central March-2012 forecast was lifted to 7 per cent from 6 per cent, with an upward bias at its last policy review.

While the RBI can do little about the seemingly structural rise in primary food price inflation, it can eradicate demand-pull pressures by producing a sustained slowdown in the broader economy. .

RBI's EFFORTS

A key passage in the policy review makes RBI's intentions clear. In discussing its policy stance, it was noted that “there is no evidence of a sharp or broad-based slowdown as yet”. The clear inference is that a “sharp and broad-based slowdown” is what the RBI has now accepted that it must engineer. With growth likely around 8 per cent, GDP growth in the current financial year (and likely FY2013 as well) will need to run below that level for some time to remove the output gap, that we estimate has built up over the last 12-18 months. The risks to the RBI's GDP forecast of 8 per cent therefore remain skewed heavily to the downside. Our forecasts for FY2012 and FY2013 remain 7.6 per cent and 7.3 per cent respectively.

Eight per cent policy rates, combined with the more effective monetary transmission that liquidity conditions should still ensure, will probably be sufficient to generate the required growth slowdown. The end of the RBI tightening cycle is now clearly in sight after Tuesday's move. The moderation in RBI's policy guidance from a “need to persist with its anti-inflationary stance” in June to Tuesday's more balanced judgment that policy will “depend on the evolving inflation trajectory” anticipates this.

MORE HIKES

However, as the policy review also makes clear, inflation risks — from the progress of this year's monsoon, to global oil prices, and the clear risk of further hikes in administered fuel and energy prices — remain skewed to the upside. To this RBI's list, we would of course add the likelihood of further upward revisions to the May and June WPI inflation data, pushing current inflation well into double-digit territory and blowing RBI's revised March-2012 inflation forecast off-course.

With several months of nasty upward inflation to come, we continue to target a further 25 BP rate hike at one of this year's remaining four policy meetings. Our year-end repo rate target therefore remains 8.25 per cent. With 2-year government bond yields steady at approximately 8.20 per cent, the bond market continues to deliver a similar verdict. Two-year yields moving below the policy rate will be a strong signal of the end of the tightening cycle.

(The author is Chief Asia Economist, BNP Paribas.)

Related Topics