RBI may take a pause by keeping policy rates unchanged
Moneylife Digital Team 15 December 2011

While WPI inflation moderated in November, core inflation as measured by non-food manufactured WPI inflation is still above the RBI's comfort level. This may make the central bank to take a pause after increasing repo, reverse repo and CRR rates 13 times since March 2010

The Reserve Bank of India (RBI) is most likely to keep policy rates unchanged at its meeting on 16th December, say economists. They feel that while wholesale price index (WPI) inflation has moderated in November, core inflation as measured by non-food manufactured WPI inflation, is still above the RBI’s comfort level and this may make the central bank to take a pause and keep repo, reverse repo and CRR rates unchanged.

“Given the balance between inflation and growth, we expect the RBI to hold the policy interest rate steady over the remaining months of the current fiscal. We think cuts in the repo rate could begin in mid-2012. We assign only a small probability to an easing in the repo rate before second quarter of 2012, unless there is a major deterioration in global economic and financial market conditions,” said Barclays Capital in a note.

In October, the RBI, for 13th time since March 2010, increased repo (the rate at which the RBI lends money to banks) and reverse repo (the rate at which the RBI borrows from banks) rates by 25 basis points (bps) each to 8.5% and 7.5%, respectively to control inflation. The series of rate hikes has cumulatively increased interest rates by 525 bps in the last 20 months.

Expressing similar views, Goldman Sachs, in a research report, said, “While we continue to believe that sequentially falling inflation and much weaker growth will prompt the RBI ease monetary policy, our expectation of the sequence of easing remains first injecting liquidity through open market operations (OMOs), which the RBI has been doing, then cut the reserve requirement ratio of banks in January, followed by repo rate cuts in March 2012. As such, we assign only a 30% probability to a cash reserve ratio cut on 16th December. We continue to expect the RBI to cut policy rates by an above-consensus 150 bps in 2012.”

WPI inflation moderated to 9.11% year-on-year (y-o-y) in November from 9.73% in October, slightly higher than market expectations due to sharp deceleration in food inflation and stable manufacturing inflation. However, non-food manufactured inflation (which the RBI refers as core inflation) increased in November to 7.9% from 7.6% in October due to an increase in the prices of metals (1.5% month-on-month or m-o-m), chemicals (0.4% m-o-m) and non-metal minerals (0.9% m-o-m).

For the week that ended on 3rd December, food inflation fell to a nearly four-year low at 4.35% reflecting a decline in prices of essential items like vegetables, onions, potatoes and wheat. Food inflation, as measured by the WPI, stood at 6.6% in the previous week. It was recorded at 10.78% in the corresponding period last year. This is the lowest rate of food inflation since the week ended 23 February 2008, when it stood at 4.28%.

A big headache for Indian policymakers at the moment is the unrelenting slide in the rupee. With the dollar in great demand and macro-economic fundamentals weak, the pressure is likely to continue on the Indian currency. Continued weakness in the currency is pushing up the cost of imports like edible oil, fuels and metals. For example, while the global crude oil prices rose by nearly 20% in November 2011 compared to a year earlier, the rupee price of oil shot up by around 40% due to currency depreciation.  

Although India is a relatively closed economy, the rupee is a pro-cyclical currency and cyclical challenges are likely to outweigh seasonal positives into first quarter of 2012. Analysts expect the rupee to weaken further due to growth concerns and capital outflows. “We expect little near-term relief for the trade deficit, as exports slow and the reduction in the import bill is limited by oil imports and investors’ huge appetite for gold. As such, we do not expect rupee strength to resume until economic expectations bottom out, spurring portfolio flows back into Indian markets,” said Standard Chartered Research in a note.

Recently, there has been much debate about whether the RBI should cut the cash reserve ratio (CRR). “The still-elevated November inflation rate will offset market pricing of immediate CRR cuts by the RBI, despite the lower lower-than-expected industrial production numbers, as well as tight liquidity conditions. We continue to expect the RBI to inject liquidity via OMOs and not via CRR cuts over the near term—until March 2012 under our base case—as CRR cuts would likely stoke inflation expectations, which are just beginning to fall,” added Barclays Capital.

The liquidity deficit in the banking system of Rs880 billion, well above the RBI’s comfort level of Rs600 billion has increased expectations of a CRR cut from its current level of 6%. According to Standard Chartered, the RBI will be in no hurry to signal a change in stance this week. “Following recent comments from the RBI that the CRR is also considered a monetary policy tool, a cut in the CRR appears unlikely. In terms of supporting banking-system liquidity, we expect the RBI to continue with its OMO. Any rate cuts will thus have to wait until second quarter of 2012 when WPI inflation cools to 6.5% to 7%,” Standard Chartered said in a report.
The government and the RBI have accepted that high interest rates may hurt the country’s growth prospects, but the apex bank has underlined that bringing inflation under control is its major agenda.

The fall in food inflation comes as a silver lining for the government at a time when the economy is experiencing a slowdown, with GDP growth dipping to 6.9% in the second quarter, the lowest rate of expansion in over two years. Industrial production has also witnessed a contraction, with output shrinking by 5.1% in October. Headline inflation, which also factors in manufactured items, has been above the 9% mark since December 2010.

The RBI has hiked interest rates 13 times since March 2010 to tame demand and curb inflation. In its second quarterly review of the monetary policy in October, the central bank had said it expects inflation to remain elevated till December on account of the demand-supply mismatch before moderating to 7% by March next year.

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