Don’t exaggerate inflation threat

Unprecedented volatility has underpinned the Indian money markets since mid-July 2013 when the Reserve Bank of India tightened liquidity and interest rates in a bid to curb pressures on the rupee.

Over the last seven weeks, the backdrop for monetary policy has, however, changed.

The rupee has regained partial stability on the back of unconventional measures taken by the RBI to attract foreign capital.

More importantly, as highlighted by Assocham earlier, the size of the current account deficit has seen a substantial correction because of measures taken by the policymakers, slowdown in domestic growth, impact of past rupee weakness and pick-up in global growth momentum.

The anticipated 43 per cent compression in CAD towards $50 billion in 2013-14 (far better than the stipulated $70 billion) along with a surge in capital inflows has decreased external sector concerns.

Rollback to continue

This led the RBI to start rolling back its tightening measures in a calibrated fashion. Since the mid-quarter review in September 2013, the central bank slashed the marginal standing facility (MSF) rate by a cumulative 125 basis points, injected liquidity through purchase of government securities, and introduced a term money market.

For today’s policy review, Assocham believes the RBI will continue to roll back its tightening measures by cutting the MSF rate further by 25 basis points with the aim of normalising the MSF-repo spread at 100 basis points.

With the MSF rate currently acting as the operative rate for monetary policy, any reduction by the RBI will lower the pressure on money market rates and signal its resolve to address weakness in domestic growth. However, the recent pick-up in inflation has raised concerns about an increase in repo rate. While there is no denying that inflation has begun to firm up, let us not get swayed by the headline print. Demand conditions continue to remain sluggish as suggested by the core WPI inflation which, at 2.1 per cent, is significantly lower than its long-term average of 4.7 per cent.

Currently, the pressure on headline inflation is coming from two sources: lagged impact of past rupee weakness which has manifested in some pick-up in imported inflation, and supply distortions caused in food prices, especially vegetables caused by the monsoon.

Temporary effect

Both these sources of inflation are likely to be temporary. The 10 per cent appreciation in the rupee over the last two months will help unwind the pressure on imported inflation, going forward. In addition, with a bumper kharif season output coming on board from November onwards, food prices will cool off.

From a structural perspective, containing inflation in perishables requires effective supply management and reforms in the Agriculture Produce Marketing Company (APMC) Act rather than a monetary policy response.

In Assocham’s opinion, while monetary policy should remain alert to shocks coming from the exchange rate and food prices, the role of dis-inflationary forces in the current economic environment cannot be ignored and should be allowed to run their course.

(The author is President, Assocham.)

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