by NR INDRAN / INT

The Reserve Bank of India’s (RBI) policy meeting on September 16 will be a close call. We expect the RBI to pause, while Bloomberg consensus expectations are of a 25-bp hike. The central bank has been very aggressive in its rate hiking cycle, raising its effective policy rate from 3.25% to 8.00% since March 2010. The pace of tightening accelerated in the summer, where it tightened by 125 bp—raising rates by 50 bp in May, 25 bp in June, and again by 50 bp in July.

Both the rate hikes of 50 bp were above market expectations. There are a couple of reasons why the RBI may be tempted to hike again. Headline yoy inflation remains high and could potentially be aggravated by a big upside surprise on the August WPI inflation reading. Further, there is inertia in policy making—once on a hiking cycle, the decision to pause is a big one. However, we think that the reasons to pause outweigh the reasons to hike. Therefore, we reiterate our long-standing call that policy rates have peaked (see The Reserve Bank of India—hikes done for now, Asia Policy Watch, July 26, 2011).

Since the last policy meeting, a further slowdown in domestic demand, inflation coming off sequentially, and a turbulent global environment has increased the option value for pausing by the RBI, in our view:

First, domestic demand is weakening significantly with nearly every activity indicator showing a slowdown. Auto sales have seen negative yoy growth for two months, the Manufacturing PMI is down to 52.6 in August from 55.3 in June, industrial production growth is weak at 3.3% yoy in July, corporate results and capital formation have been weak, and the full effect of the rate increases are yet to show in activity indicators.

Second, inflation has come off sequentially. While the yoy headline numbers have remained elevated as expected, the qoq; seasonally adjusted, annualized numbers are now down to 5.0% in July. With a good monsoon, and the worsening global environment likely to mitigate the upside to commodity prices, and a helpful base by the end of the year, the risks to inflation are to the downside.

Third, we need to take into account lags in monetary transmission. The recent aggressive hikes would have an impact only in the second half of FY12. Tightening further would have an impact only in another 2-3 quarters by which time activity and inflation will likely be significantly weaker by the RBI’s own forecasts.

Fourth, the objective of getting ahead of expectations has been achieved.

Fifth, the uncertain global environment and the volatility in the stock market have already tightened financial conditions by more than a small rate hike could achieve. There are risks that the global headwinds could tighten financial conditions further.

We expect the RBI’s policy statement to remain hawkish—with a reference to inflation remaining the chief concern. The RBI’s FY12 growth target of 8% and end-March 2012 inflation target of 7%, we think are likely to surprise on the downside. The RBI may therefore mention downside risks to its growth target, but may not explicitly lower it. Finally, we think the statement is likely to suggest that the RBI is on a wait-and-watch mode rather than explicitly signal the end of the tightening cycle.

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