The Reserve Bank of India is scheduled to announce its last quarterly monetary policy of the calendar year on October 25. The central bank is likely to announce a 25 basis point hike in the reverse repo rate to 5.25 per cent, and issue a hawkish monetary policy statement.
At its last quarterly review in July, the RBI unexpectedly kept interest rates unchanged, and -- more surprisingly -- sounded dovish in its monetary policy statement, despite the ongoing economic strength. At that time, Governor Y V Reddy indicated that the "...balance of convenience at this juncture lies in continuing with status quo."
However, since that announcement, global financial markets expect a more aggressive Fed, and central banks around the world have turned more hawkish. Indeed, the RBI now finds itself facing circumstances that call for firm action.
Economic growth: India's growth outlook remains upbeat with the economy firing on all cylinders. Full-year GDP is forecast to increase 7.2 per cent on a year-on-year basis in 2005-06, led by service and industrial sectors, and carries upside risk. On the demand side, GDP growth will be powered by surging consumer spending, impressive gains in exports, and pickup in investment.
India's GDP growth in the April-June quarter accelerated to 10 per cent on a seasonally adjusted annualised rate (saar) to leave the level up 8.1 per cent on a yoy basis. Non-agriculture GDP growth was stronger than the headline GDP outcome, growing 13.3 per cent quarter-on-quarter (q/q), saar (9.8 per cent yoy), sharply higher than the previous quarter's 7.8 per cent (8.4 per cent yoy).
The current pace of expansion is above the most likely GDP and non-agriculture GDP growth outcomes for the next couple of years, and is likely to increase demand-driven inflationary pressures.
Inflation: The favourable impact on yoy wholesale price index inflation owing to last year's high base will soon disappear. Indeed, on our forecast, WPI inflation for end-March 2006 is likely to be 5.5 per cent yoy, the top end of the RBI's forecast range of 5.0-5.5 per cent yoy. Higher crude oil prices and the current strength of India's economic expansion hint at upside risk to our inflation forecast.
To be fair, India's WPI inflation would have been higher had it not been for the government's intervention to prevent a greater -- if not complete -- pass through of the higher global crude oil prices.
However, that approach is clearly unsustainable, with little hint of the timing and magnitude of the next round of economic pressures that would force the government to hike local fuel prices.
Indian financial markets are misinterpreting the impact of structural reforms on inflation and on the RBI's inflation comfort level. Increased competition and structural reforms in India have undoubtedly lowered the underlying inflation rate.
But they have also rightly lowered the inflation comfort threshold of the central bank, and investors should pay attention to this adjustment. In the absence of such an adjustment in the RBI's comfort zone for inflation, monetary policy could mistakenly remain too easy for too long, likely forcing the central bank to overreact at a later stage.
Importantly, C Rangarajan, former RBI governor and current chairman of the prime minister's economic advisory council, has reportedly said that the government should be worried about inflation if it crosses the threshold limit of 5-6 per cent.
That limit will likely decline further depending on the pace at which structural rigidities are removed and how fast India integrates with the rest of the world, but for now the RBI should start acting before inflation exceeds that range.
The RBI should take note that the telltale signs of higher demand-driven inflation are coming into place: private sector hiring is brisk and salaries are posting strong increases, consumer spending remains strong, residential property and equity prices have surged, business investment is picking up, non-food credit is growing briskly, and manufacturers appear more confident of their ability to pass on a larger portion of their higher input costs to consumers. Also, indictors of rural spending appear encouraging, and are likely to post a seasonal pickup in the next two-three months.
Exchange rate and balance of payments: The recent weakness of the rupee is unlikely to influence the RBI's upcoming interest rate decision. Indeed, by being largely absent from the foreign exchange market, the rupee's weakness appears to have the RBI's blessing.
Apart from the dollar's strength, oil-related onshore dollar buying and lower net equity inflows are the key reasons for the rupee's weakness, and they are unlikely to be critical in the RBI's forthcoming decision to hike rates.
Though the pace of rupee depreciation has been excessive given the RBI's track record, we maintain that the rupee is poised to weaken further, to 45.5 by end-March 2006 and 46.0 by end-December, and flag upside risk to the forecast.
Rajeev Malik is senior economist with JPMorgan Chase Bank in Singapore. Views expressed here are personal
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