Continued Tightening of Interest Rates may keep Economic Expansion below 8.5%

The Reserve Bank of India (RBI) raised rates for the second time in July. This is not what we expected it to do, given the rather soft attitude so far on rates. Yet it looks like the inflation hawk has struck hard. But has the RBI really changed its thinking or is it being forced to change? Even though the monetary policy document is very clearly in favour of squashing the inflationary pressures, subsequent comments and movements at the RBI indicate that there is considerable dissent within. What are the issues at stake? 

The RBI has always maintained that inflation has been driven by food prices and with a good monsoon now and higher sowing in the kharif season so far, these prices should be coming down. It is true that the inflation estimate was revised upwards for April. Inflation was, therefore, worse than was thought earlier. The rise in fuel prices too will put a pressure on prices across the board. But it is also true that it is the government which is to be blamed for the high food prices and pathetic stock management. Unfortunately, apart from some finger pointing at the state governments, there does not seem to be any impending change by the government. The trouble is that even though inflation appears to drop to 6% levels by the year end, there are enough pressure in the system to push the RBI for more aggressive hikes, more than the expected additional 50-75 basis points by the year-end. 

To make matters worse, industrial growth is already on its way down, but faster than was expected. In the first revision to the provisional numbers for April, Index of Industrial Production (IIP) growth fell by more than a percentage point. Whether we look at unadjusted growth numbers or to a three-month moving average series of seasonally adjusted annual returns, the trend is clear. While May numbers stood at 11.3% year-on-year, we expect the quarter ahead to turn in growth around 8%. The economy is expected to grow at 8.5%+ rate this year, but with tightening of interest rates this may not be actually achieved. With slowing down of manufacturing growth, the upward momentum will continue to be powered by the service sector and this seems to be what the government is more comfortable with. 

Looking ahead, there are lots of trouble spots still. While the area sown in most crops is higher than last year, pulses and oilseeds remain below the 2008 levels. These will continue to be pressure points for Indian households. Global crude prices will be volatile and the range of $70-90 a barrel is sufficient to wreck a lot of inflation estimates. To top it all, there is still no clarity on the fuel decontrol mechanism. Whether it is changing fundamental systems of food stock management or implementing a policy already announced, this government seems intent on moving slowly on issues that matter. 

The net result is that the government will continue to compensate for its mismanagement by taking actions that will impact growth. The fall in IIP growth is cause for concern and if the government does not get its act together the 8.5% expectation will need to be lowered. 

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