On the eve of its third quarter policy review, the Reserve Bank of India seems to have only one goal and policy option. It is usual for such reviews to articulate the several policy choices, the most prominent is growth versus price stability. This traditional dilemma remains but for a variety of reasons it has been relegated to the background.
The RBI Governor has said that the central bank is desperate to rein in inflation. Chairman of the Prime Minister's Economic Advisory Council C. Rangarajan has called for a rate hike. The real issue seems to be not whether the RBI will raise the policy rates but by how much. Most observers think a 0.25 percentage point hike is definitely on the cards. But others feel that the hike will be higher by 0.50 percentage point.
The reason why a rate hike seems inevitable is, of course, inflation, which remains stubbornly high. In December, WPI inflation shot up to 8.5 per cent on a year-on-year basis having moderated from 11 per cent in April to 7.5 per cent in November. In fact, after remaining in double digits for five successive months, WPI inflation declined to 8.8 per cent in August. By that time, the RBI was in a position to say ‘that the likelihood of further rate actions in the immediate future is low'. That statement was, however, subject to numerous caveats. Inflation can never be out of the central bank's focus. In any case, the sharp spike in December has put paid to all talk of a ‘more permanent pause' in monetary action. The RBI has admitted that its year-end target for WPI inflation at 5.5 per cent is unlikely to be achieved.
Special challenges
Among the emerging economies, India is not the only one facing inflation amidst robust economic growth. Brazil and China are also facing similar predicament, inviting strong monetary measures to curb inflation. But in most of the developed world the threat of inflation is in the distant horizon. As the RBI Governor has pointed out, the main worry in those countries is deflation. One of the main challenges before policymakers is to categorise the latest bout of inflation.
Since food prices have been driving up inflation, supply side factors are held to be primarily responsible.
However, the inflation process is much more complex and cannot be categorised into neat compartments such as demand-supply, food-non food and domestic-international. The price rise is due to factors emanating from all sides and that makes the RBI's task much more complex.
For monetary policy purposes, the WPI in use is not the most appropriate. Other countries use a representative Consumer Price Index or a Producer Price Index (PPI). Recently, the WPI was upgraded, by including a number of items that are relevant today and deleting those that have become obsolete. The base year was brought forward. Despite all these, the search for a new CPI continues.
Inflationary pressures today are underpinned by a number of factors.
(a) Economic growth has accelerated and this has created its own upward pressures. Some producers are discovering their pricing power.
(b) Global commodity prices, especially petroleum, have been rising. Recently retail petrol prices were raised yet again. The government is holding on to the diesel prices, which, unlike petrol prices, are yet to be decontrolled. Either way, inflation or inflation expectations are set to rise. Surely, the subsidy bill will go up.
(c) Non-food manufactured goods inflation now at around 5.3 per cent is bound to go up as the high global commodity prices get reflected in domestic prices.
(d) The government's rural initiatives and social sector spending have boosted aggregate demand.
(e) There is a growing demand for protein products, milk, eggs and meat. Prices of these have gone up and are behind the surge in food inflation. In contrast cereal prices, wheat, rice and pulses have not risen.
(f) The loose fiscal policy and the slow pace of fiscal consolidation are the other important factors.
It is the persistently high food inflation that has become the rallying point for all — political opposition to government policies. So sensitive it has become that the rising food prices would by themselves force the RBI's hands. Food inflation has eased marginally to 15.52 per cent for the week ended January 8. Unlike in the recent past, when high food prices were blamed on supply side factors, this time there are demand side factors too. The central bank can do very little to alter the supply of essential commodities by varying interest rates. Moreover, since any policy action operates after a lag, it will not be effective in situations where food inflation is temporary. However, when prices of food stuff remain high for a long time, inflation expectations will harden, necessitating a rate hike, among other measures.
Rate hike unavoidable
On balance, therefore a rate hike seems unavoidable. But the extent of increase — beyond the almost certain 0.25 percentage point — will depend on a number of factors. The central bank's estimate of GDP growth for the current year will be one factor. So far despite the impressive 8.9 per cent growth during the first six months, the RBI has been conservative and has stuck to its 8.5 per cent estimate made earlier in the year. If the erratic but generally lower Index of Industrial Production numbers are any indication, economic growth may be slowing down in a crucial sector.
Strictly from the monetary side, the case for an aggressive monetary tightening, say, by 0.5 percentage point does not seem to exist. Broad money supply has been growing as per RBI's expectations. The money market has witnessed periodic bouts of liquidity shortages. However, besides the high food prices, the rise in global commodity prices, especially of petroleum, will force the RBI to act through a widely anticipated 0.25 percentage point hike.
The tone of the policy statement is bound to be hawkish, leaving no one in doubt that inflation will remain the main concern in the days to come.
