Monday, January 27, 2014

India's New War on Inflation

The Reserve Bank of India (RBI) is likely to leave interest rates untouched at its monetary policy meeting Tuesday. However, much attention will be focused on this meeting, especially after the release of a hawkish report by the central bank's panel tasked with reviewing the effectiveness of the existing monetary policy framework.

Markets were on the edge, also weighed by RBI Governor Raghuram Rajan's reference to inflation as a "destructive disease", indicating that rates may need to remain high. In a departure from tradition, the quarterly report on Macroeconomic and Monetary Developments, for the December quarter, will be released alongside the review, not a day earlier as is usual practice.

The odds of a rate hike have admittedly risen since the release of the panel report, but the need to ascertain the inflation trajectory and allow 50 basis points worth of hikes (between September and November) to take effect could lead the RBI to leave the benchmark repo rate on hold at 7.75%.

The policy statement is expected to reiterate limited tolerance for inflation and reveal the extent to which the panel's proposals will be adopted. The panel report recommends the use of consumer price index (CPI) inflation as the nominal policy anchor, a sign that the RBI seeks to gradually move towards an inflation-targeting regime.

The numerical goal is to lower inflation to 8% in a year and 6% in 24 months, before adopting 4% (give or take two percentage points) as the official target. The report broadly mirrors the policy guidance of RBI Governor Rajan, increasing the likelihood of its recommendations being adopted in full or to a large extent.

The move to an inflation-targeting regime is a step in the right direction, but the timing of the shift will depend on a few factors. Firstly, adherence to any hard target involves some consultation with the government. In the absence of a cohesive plan, policy might be tightened more than necessary, without resulting in a commensurate easing of inflation. It must be noted that Finance Minister P. Chidambaram has termed the panel's CPI target as ambitious and that the central bank needs to balance inflation risks along with a supportive growth stance.

Secondly, an immediate adoption of the report's goals would translate into an immediate and aggressive rate hike. This seems unlikely as CPI inflation has eased from August-November highs. Barring any domestic supply or global commodity price shocks on the horizon, a case may be made for the headline CPI to ease gradually from now on.

Rates are likely be left untouched in the near-term, barring surprise developments such as higher oil prices, currency depreciation or supply shocks, which could mean hikes. However, rates will clearly remain high for a long period and any call for rate cuts is certainly off the table.