The RBI and its inflation dilemma

October 18, 2012

(Arvind Chari is a senior fund manager of Quantum Asset Management Company Private Limited. The views expressed in this column are his own and do not represent those of either Quantum AMC or Reuters.)

The wholesale price index number for September (7.81 percent) poses a dilemma for the Reserve Bank of India (RBI). With the finance ministry leaving no opportunity to make its case for lower interest rates and exhorting the RBI to take ‘calibrated risks’, the recent inflation data gives no comfort to the RBI to go ahead and confidently cut the repo rate in its October policy review.

The headline WPI number was expected to be higher than the previous month on the back of an increase in diesel and LPG prices. The RBI has factored in the rise in fuel prices in its March inflation target and would overlook the recent increases for the time being as fuel price hikes also go about solving the fiscal deficit problem. Although headline inflation would remain high in the months to come, the RBI would choose to ignore domestic fuel price increases as a policy action needed to correct the fiscal imbalance.

But the central bank would have certainly hoped for lower manufacturing and food inflation. Despite the overall industrial slowdown, manufacturing inflation remains above 6 percent, as against the RBI’s comfort level of around 5 percent. Core inflation, a flawed but popular measure of tracking inflation, has also been consistently above the 5.5 percent mark in the last 3 months. For the RBI to be comfortable with the future inflation trajectory, given the backdrop of volatile food prices in India, manufacturing inflation needs to remain below 5 percent. This is not quite the case today.

If the headline WPI inflation reading moves above the 8 percent mark in 2-4 months on the back of fuel price hikes and the base effect of food prices, justifying a rate cut on inflation numbers is going to be extremely difficult.

We continue to believe that rate cuts are dependent on 3 factors

– stable or lower food inflation

– fall in global oil prices and

– sustained rupee appreciation

We have seen some rupee appreciation in September and despite the poor monsoon, food prices have remained stable. But global oil prices are yet to show any meaningful correction. The RBI would be hoping for some more rupee appreciation driven by government action and a drop in oil prices before the U.S. elections, to be able to create some room for rate cuts. But the issue with such an approach is that markets prices are transitory and reversals could leave the RBI on the wrong foot.

Given its limited ability to cut rates, the RBI has at least ensured that market liquidity is comfortable — which has led to a faster and a larger drop in market interest rates in the last six months. The CRR cut in September was an indication of the RBI’s intent of keeping the liquidity deficit under check and further lowering short-term interest rates. Banks today are flush with liquidity and have also seen a fall in their funding costs. Most banks have reduced their deposit and lending rates in the last two months.

Although the clamour for a rate cut is high and it has a direct impact on sentiment, a comfortable liquidity situation this year has resulted in a significant fall in market interest rates and the cost of funds for banks. So even if the RBI is unable to cut the repo rate on Oct. 30, we still expect market interest rates and funding costs to remain benign as the RBI would infuse further liquidity into the system through CRR cuts or open market operations (OMO).

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