Even though the government has announced a slew of measures to stimulate the economy, the Reserve Bank of India (RBI) is likely to maintain the status quo while reviewing its policy in the forthcoming mid-quarter review on Monday, as inflationary pressure still plagues the RBI. “We believe the RBI would maintain the status quo in the forthcoming meeting. However, in subsequent meetings, we expect that a sharp slowdown of economic activity would prompt the central bank to ease the repo rate by 50 basis points in the rest of the year,” said Upasna Bhardwaj, Chief Economist, ING Vysya Bank, on mid-term policy review.

With the recent record hike in diesel price, the government has indeed intended to give a strong message to market participants of its intention to continue its efforts towards fiscal consolidation.

While this definitely is a positive move, and helps in partially removing the suppressed component in inflation, it does skew the inflation trajectory on the upside. Coupled with that is the expected rise in commodity prices due to the announcement of additional liquidity injection. Oil prices have already reversed the trend since July on improved risk sentiments.

“We expect inflation to largely range between 7.5 per cent 8 per cent in the second-half of the current fiscal, with the average inflation at 7.6 per cent for the year,” said Ms. Bhardwaj.

Apart from the fuel price hike, another factor increasing the risk of higher inflation is the recent quantitative easing- 3 (QE-3) announcement by the U.S. Federal Reserve. Global risk rally is likely to push commodity prices substantially higher, raising the risk of imported inflation. While the adverse impact on inflation is given, the extent of the impact of QE-3 on inflation remains debatable, given that risk-on would also support the rupee, partly offsetting the effect. Wholesale price index-based (WPI) inflation for August was 7.55 per cent year-on-year, much higher than the market expectation of 7.10 per cent and the previous month’s estimate of 6.87 per cent year-on-year. The final figure for June was revised up by 33 basis points to 7.58 per cent. The high inflation was mainly led by surge in fuel prices and manufactured products.

CRR cut

“We expect a 25 basis point cut in CRR in the September 17 policy to cut lending rates with growth set to slow below the RBI’s 6.5 per cent forecast. Unless lending rates come off by, say, 100 basis points (25-50 basis points done), the modest growth forecast of 5.6 per cent for 2012-13 may be difficult to achieve. India is the only BRIC (Brazil, Russia, India, China) in which lending rates are stuck at peak 2008 cycle levels,” said Indranil Sen Gupta, India Economist, DSP Merrill Lynch (India).

“In the forthcoming mid-quarter monetary policy review, the RBI is likely to keep both policy rates and CRR unchanged,” stated a report prepared by Edelweiss Securities Limited.

Going by the central bank’s guidance in recent months, containing inflation and inflation expectations remains the dominant policy objective despite the deterioration in economic growth prospects. Therefore, since headline inflation remains elevated and may inch higher in the coming months due to a likely rise in agri-inflation, “we do not foresee RBI easing interest rates.” Edelweiss added.

During the last couple of months, liquidity situation has improved considerably because of RBI’s sustained open market operations in the first-half of the current fiscal. Also, with the RBI’s interventions in the foreign exchange market, rupee volatility has largely stopped. This, along with a slowing credit growth, has led to an improvement in liquidity conditions. At present, liquidity adjustment facility borrowing by banks is Rs.35, 000-40,000 crore (on an average). Accordingly, said Edelweiss, “We do not expect a CRR cut in the September policy meeting.” As headline inflation is expected to remain elevated till the third quarter of the current fiscal, markets expect RBI to keep policy rates on hold and cut rates by 50 basis points only towards the fourth quarter of this financial year.

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