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India
Time to step it up: Preview of RBI's 3 May rate decision
A rate hike on 3 May is given, but the question is by how much. The case for 50bp is very compelling,
with growth holding up and demand-led price pressures now the main driving force behind the
increasingly grim inflation outlook. Also, the liquidity deficit has shrunk. While there is a risk that RBI
may decide to limit the move to 25bps, citing emerging growth risks, we are holding up our hopes that it
will deliver a more decisive move to avoid falling too far behind the curve and help better anchor
inflation expectations.
The inflation problem has worsened since the last policy meeting. WPI inflation jumped in March to 9%
y-o-y (vs. 8.3% y-o-y in February), which was well above consensus (8.4%) and our higher forecast
(8.5%). Moreover, monthly sequential inflation rose to 1.1% m-o-m sa (vs. 0.9% in February).
Importantly, a key driver of this was a broad-based pick up in core inflation (7.1% y-o-y vs. 6% y-o-y in
February), which eased a bit on a m-o-m sa basis (1.0% vs. 1.5% in February) but accelerated on a
3m/3m SAAR basis (10.2% vs. 9.1% in February). Another driver was higher energy prices (12.9% y-o-y
vs. 11.5% in February). Food price inflation continued to ease on the back of improving supply, but the
recent downtrend also reflects the high base early last year when food prices were driven sky high
following the dry monsoon in 2009.
At the same time, growth is holding up and is not an immediate concern. While industrial production
numbers have been somewhat soft in recent months, this was primarily led by the capital goods segment
and partly reflected base effects as well as a delayed rollout of various investment projects held up at the
Ministry of Environment. Although the monetary tightening undertaken so far likely played some role,
this has not affected the production of consumer goods, which has continued to grow briskly. Moreover,
PMI readings show that the momentum in both the manufacturing and services sector is holding up well,
and credit growth remains strong.
The solid growth momentum is manifesting itself in tighter capacity, foreshadowing a continued build-up
in demand-led price pressures and, thereby, core inflation. The tight capacity is showing up in rising
backlogs of work (as per the PMI sub-indices) and a record-high number of companies reporting that they
are operating above optimal levels. Also, cross-country surveys show that employers in India are planning
to fork out larger wage increases compared to its Asian peers, reflecting tight labour market conditions.
Anecdotal evidence from the PMI surveys also point to difficulties filling vacant positions.
So, what does this all mean for the inflation outlook? Taking all these factors on board, we expect that
WPI inflation will average 8.3% y-o-y in FY2012, well above consensus and RBI's comfort zone. Core
inflation and energy prices will continue to add to inflation pressures in the coming months, while food
inflation will ease in annual terms. However, annual headline WPI inflation could begin to creep up again
later in the year as the base effect currently holding down food inflation drops out, a factor not
sufficiently appreciated in our view.
Accordingly, the case for continued tightening is strong and the RBI may now finally be compelled to
step it up and hike by 50bp rather than 25bp. This is primarily because the inflation outlook has worsened
noticeably, but also because the RBI should now feel less constrained by factors previously holding it
back. First, inflation is increasingly driven by demand- rather than supply-side factors as core inflation is
taking over as a key driver of cost pressures. Previously, RBI used the argument that the predominantly
supply-driven nature of inflation justified their gradualist approach. Their argument was that more
aggressive tightening came with the risk of having a limited impact on inflation while having a
disproportionate impact on growth. This argument has now lost its power. Second, liquidity conditions
have eased significantly in response to RBI's liquidity enhancing measures as well as the stepped up
execution of government spending during the opening month of the fiscal year. Having topped out at
around INR1,700 billion in late December, the liquidity deficit is now down to an average for April of
just INR75 billion. So, this should not hold it back either.
On balance, therefore, we believe that RBI will be swayed to move by 50 bps. But, it is not given. It may
feel tempted to just move by 25bps due to the emerging "risks to growth" from both domestic
(investments) and global sources (elevated oil prices) they noted in their latest policy statement. However,
we are holding up our hopes that RBI will be sufficiently concerned about falling too far behind the curve
and, consequently, go for a more aggressive move this time around. If they don't, they risk having an even
bigger inflation problem on their hands, which would, eventually, be more growth destructive than a preemptive strike through a bigger rate hike. Also, a more aggressive move at this juncture, with inflation
repeatedly surprising on the upside, would more clearly demonstrate RBI's intent to address the inflation
problem proactively. In turn, this could help better anchor inflation expectations, which have also been
trending up. To keep these in check, the RBI may even need to go beyond our current call for 75bp in rate
hikes for 2011 as a whole.
What we think: The case for continued tightening has strengthened and we think that there is a good
chance that RBI will step it up and hike by 50bp. While they may still feel tempted
to just do 25bp, the significant worsening of the inflation outlook and the shift
towards demand-led inflation dynamics should convince them that a gradualist
approach is insufficient and would leave them too far behind the curve.
