Inflation in India is rising - the headline rate reached a four-and-a-half year high of 7.0% in the week ending March 22, 2008 - but Chetan Ahya and Tanvee Gupta in Morgan Stanley's latest Global Economic Forum wonder if monetary tightening is the right response.

This period of rising inflation is unlike the last period when inflation accelerated beyond the central bank's comfort zone (November 2006 to March 2007): Domestic demand and the overall growth trend have slowed down significantly and industrial production decelerated to a four-and-a-half-year low of 5.3% in January 2008. This inflationary cycle, according to Ahya and Gupta, reflects higher global commodities: base metals, fuel and food items.

The government's use of fiscal measures and moral suasion may bring inflation to below 7%, they continue, but not within the central bank's comfort zone. Some argue that at its next policy statement on April 29, the central bank will announce a policy rate hike, a necessary step to manage inflationary expectations. The Morgan Stanley analysts are unconvinced:

In our view, monetary tightening is not the ideal solution, as domestic growth has decelerated sharply. The relatively high level of lending rates has already resulted in a sharp reduction in consumption growth. Leveraged spending by households has already declined sharply, as reflected in two-wheeler sales, consumer durables production and mortgage lending growth. Consumer goods production growth has decelerated sharply to 4.3% during the three months ended January 2008 from a peak of 18.5% in June 2005. Two-wheeler sales have been declining year on year for the past 11 months (not including the slight recovery in March due to a cut in the excise tariff). Growth in fresh mortgage disbursements has remained low at single-digit levels for the last few quarters.

Furthermore, exports have suffered a slowdown due to both weakening global demand and the rupee's appreciation. That puts two out of the three key engines of growth - consumption, exports and capex - on the downside. Morgan Stanley expects investment growth to slow, too, over the next six months, and consumption to fall further.

What then would Ahya and Gupta recommend to the Reserve Bank of India?

We believe that the RBI will likely keep the repo rate (the rate at which it injects liquidity) on hold at the next meeting on April 29. We believe that if the CRB Commodities Index increases by another 5-8% from current levels and capital inflows remain positive, the RBI could allow further appreciation of the rupee to some extent. If commodity prices rise by 10% or more and capital inflows continue to be positive before April 29, the RBI could initiate a hike in the cash reserve ratio [CRR] and/or reverse repo rate (the rate at which it absorbs excess liquidity) by 25bp on April 29. We believe that the most relevant measure for assessing the financial condition would be the banks’ lending rates. We believe that any move by the central bank that results in a hike in domestic lending rates could push GDP growth below our estimate of 7.1% for F2009. (Note that our estimates are already below consensus GDP growth, which is estimated at 8% as of mid-March.) Similarly, if the CRB Commodities Index declines by 8-10% over the next few days, the RBI is unlikely to take policy action on April 29, as this would take away the inflation pressure.

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Gary Smith

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