RBI must ignore WPI hike, driven solely by food items
Given this is the third month in which WPI inflation has started trending up, from a low of 4.6% in May to 6.1% in August, it is not surprising that many experts have begun to talk of how RBI needs to keep interest rates constant at its next meeting, on September 20, more so since the US Fed is very likely to announce the beginning of its taper. With bond rates certain to rise in the US, by even a full percentage point over the year, the logic is that India needs to keep interest rates high to attract debt funds, to offer households in India a positive real return and, most important, interest rates need to be kept high to break the back of inflation.
There are several problems with this argument, the most important being not understanding the cause, and therefore the cure, for inflation. While overall inflation has risen 31bps between July and August, there was a 91bps fall in inflation for manufactured products while that for food products rose 627bps. Obviously what matters is not just the absolute numbers, but their share in the overall consumption basket. Looked at in that manner, while inflation rose 0.36% in August, that in fruits and vegetables rose 0.97% (of which onions were 0.23%)—in other words, the hike in food prices was neutralised by the fall in inflation in manufactured goods. Indeed, ex-food and ex-energy WPI fell to 1.4% in August, down from 2.4% in just the previous month, the lowest for the last 45 months—RBI's core inflation index, a modified version of this, fell to 2% in August, the lowest reading since December 2009. Since raising interest rates cannot control food prices, the more important aspect is what damage this will do to other sectors of the economy. Indeed, given how more FII money in India is invested in equity markets than in debt ones—$145 billion versus $11 billion—a lowering of interest rates will probably be more beneficial in terms of what it will do to help corporate bottomlines. Indeed, even if US interest rates were to rise 50-75bps over the next 6 months as a result of the taper, it would be naive to expect that a similar hike in Indian rates will keep FII debt money interested or cause that to rise.
In the more immediate terms, interest rates rose by over 200 bps between July 15 when RBI tightened liquidity dramatically and August 19 when rates went up to as much as 9.24% for 10-year paper—these have now come down to 8.43%, still 112 bps over July 15. Indeed, the immediate impact of this was to leave banks facing a possible mark-to-market loss of over R40,000 crore—this was tackled by RBI giving banks a relaxation for mark-to-market norms. Even if RBI Governor Raghuram Rajan wants to factor in the US taper before formalising his monetary policy stance, reversing the measures of July 15 is probably a good first step, more so because it made a complete mockery of the traditional channels of monetary policy transmission.