RBI has given guidance but will inflation oblige?
RBI is saying rate hikes are over for the present but inflationary pressure still exists. The central bank maintained its forecast of a 7% inflation rate at the end of March 2012 even as it raised the benchmark repo rate by 25bps to quell rising inflation expectations. The rate hike was accompanied by a statement that the RBI may not need to raise policy rates in its December 2011 policy review, as inflation will start trending down from levels of 9% and above.
The RBI is more confident of inflation being contained on the back of falling demand. Aggregate demand a key demand side inflation factor is expected to come off on the back of past policy actions and global economic slowdown affecting investment and private consumption demand. Investment intentions have fallen sharply in the first quarter of 2011-12 with Rs 80,300 crores of projects sanctioned against Rs 1,42,800 crores of projects sanctioned in the first quarter of 2010-11. Private final consumption expenditure growth fell from 9.5% in first quarter 2010-11 to 6.3% in first quarter 2011-12. The RBI expects export growth to slow down from 51.8% levels in the April-September 2011 period on the back of slowing global economic growth.
The RBI is not confident of inflation coming off due to uncertainties on the supply side. The central bank has highlighted inflation risks in the form of oil prices, food prices and administered fuel prices including coal. Rising global oil prices is an ever present threat to inflation expectations. The administered prices of fuel in the country lead to non pass through of commodity prices to the end user and reflects a latent inflation. Food prices especially protein rich food prices where there are structural imbalances will pose problems for inflation down the line.
The markets are already cheering RBI guidance on policy rates. RBI’s comment on the last of the rate hikes coupled with a reformist savings rate deregulation measure has enthused a strong rally in equity markets, with the Sensex and Nifty rallying by over 2% each. Bond yields too fell by around 6bps post the policy announcement while the Indian Rupee gained over half a percent against the US Dollar. The interest rate swap curve has started flattening with the five over one OIS (Overnight Index Swap) spread flattening by 9bps to close at a negative 78bps spread. In all likelihood markets will look to embrace the positive sentiment of the last of the rate hikes, until there is a real threat to inflation that surprises the markets and the RBI.
The RBI on its part will hope that its inflation forecasts come out right as it has given a guidance to the market on its expected future course of action. RBI is still not fully confident of its take on inflation as seen from the inflation dynamics presented in the policy, but it does look as if policy rate hikes are on their last legs given the rate hike spree of 175bps over the last five months.