India: RBI to tighten again, perhaps even aggressively :JPMorgan

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India: RBI to tighten again, perhaps even aggressively

The question facing the RBI is not whether the economy is slowing, it is; but whether the economy is slowing sufficiently for inflation to come down without further rate hikes. The data so far doesn’t indicate such a slowdown. So this Friday, the RBI will likely raise rates. A 25bps hike appears the more obvious choice, but one shouldn’t be surprised with another 50bps increase. Asking the right question It is undeniable that activity in India is slowing. Most high frequency indicators point to the same including July IP growth and August PMI falling to their lowest in more than a year. Add to that the weak economic data coming out from the rest of the world and it isn’t hard to imagine why the market is pricing 50-75bps rate cuts in the near term. But this perception seems at odds with reality. True the economy is headed to decelerate further but this isn’t the question that is likely worrying the RBI. The 11 rate hikes over the past year were designed to do precisely this, i.e., slow the economy. Instead what is likely keeping policymakers in the RBI awake is whether the coming slowdown is sufficient to cool core inflation without further rate hikes. And the answer is probably not. Take away the volatile capital goods component and non-capital goods IP grew 6.7% in July, the fastest in 4 months. August PMI has declined but it still is one of the highest in the world. Indirect tax for the first five months of this fiscal year (April-August) was up 24%, well above budgeted target and despite the cut in customs duty on petroleum products. Even after slowing from its frenetic pace over the last 6 month, exports grew 44% in August and import growth jumped to 41%. We don’t know the breakdown between oil and non-oil imports as yet but given the lower oil prices in August it is likely that much of the increase came from non-oil imports. And true that gold imports could well have played a big part, but contrary to received wisdom gold import has been cooling off in recent months. All this indicates that activity has not slowed as much as feared. Proof of the pudding But the proof of the pudding is in the eating. And this is where yesterday’s inflation print for August looks scary. Far from slowing, inflation accelerated to 9.8 % significantly higher than July’s 9.2% print. And the details were decidedly unnerving. Reversing their declining trend over the last few months, domestic input prices (non-food primary and minerals) increased sharply. And core inflation jumped 0.5% on a monthly basis, the highest sequential increase in the last four months, pushing the year-on-year rate to 7.7%, almost twice its historical average. So even in August, domestic demand was sufficiently strong for firms to keep passing higher input costs into final goods prices. There aren’t many ways to bring down core inflation The real problem is that for core inflation to start declining on its own, output gap has to turn negative on a consistent basis, i.e., capacity constraints have to ease sufficiently. The recent 2Q11 GDP growth came at 7.7%. By our best estimate trend/potential growth has declined to around 7.5% and the output gap (actual growth less trend growth) has increased to close to 1%. For core inflation to come down this gap needs to turn negative as it did in 2009. (Note the close correlation between the output gap and core inflation in the chart below). This requires growth to slow significantly below trend and thus far the data isn’t indicating such a slowdown.     Don’t rule out a 50bps hike So the RBI will need to tighten more to slow the economy further. Rather than pause or cut rates, a rate hike seems well on the cards this Friday. A 25bps hike looks the most obvious choice given that this is a mid-quarter policy review. But one shouldn’t be surprised by another 50bps. The advantage of doing a 50bps is that the tightening cycle can be brought to an earlier end rather than being dragged out painfully. It will also give the RBI the space to pause in October if the need arises. The earlier inflation peaks and growth troughs, the earlier the macroeconomic uncertainty looming over private investment will be resolved. And India Inc can go back to rebuilding capacity, which is what is really needed to bring down inflation in the medium term.