India’s central bank battles alone in inflation struggle

April 19, 2011

INDIA-ECONOMY/RATES What more does India’s central bank have to do? Last week data showed March inflation rising to almost 9 percent on an annual basis. More importantly, core inflation is above 7 percent for the first time in 3 years meaning demand-side pressures are rising fast. And that’s despite the Reserve Bank of India raising interest rates eight times since last March.

The inflation data comes just after a quarterly HSBC report based on purchasing managers indexes showed that inflation in India seemed impervious to monetary policy tightening.

The truth, is the inflation-fighting central bank has little backup from the government which remains stubbornly in spending mode. Its foot-dragging on reform and foreign investment contributes towards keeping food price inflation high. This year’s fiscal deficit target is 4.8 percent of GDP and even this
is seen as optimistic.

“What India really needs is to have domestic demand slowing down quite rapidly but the government is not prepared to risk that,”says Claire Dissaux, investment strategist at Millenium Global in London.

The RBI has repeatedly said it shouldn’t have to do all the heavy lifting. But lack of support from the government means the central bank will have to put up rates another 100 bps this year, analysts reckon.

Of course India is not alone in this bind though it is the most extreme example of lax fiscal policy being counterbalanced by tight monetary policy. Brazilian interest rates are among the highest in the developing world at 11.75 percent and that is down to loose fiscal policy, a lot of it “quasi-fiscal spending” via the state development bank BNDES, research house Capital Economics says.

Brazil’s central bank suggested recently that fiscal tightening of one percent of GDP would have the same impact as 125 bps of interest rate hikes.

Meanwhile the high-growth, high-inflation gamble carries its risks. Investment banks have been cutting their India growth forecasts for the current fiscal year, citing the risks from inflation.

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