RBI likely to hike rates in September

Factory output in June grew 8.8 per cent over the corresponding period last year, outstripping the consensus growth rate of 5.5 per cent forecast by 23 economists polled by Bloomberg. This sets the stage for another round of interest increase by Reserve Bank of India (RBI) in September.

The factory output data comes on the heels of a week of largely negative global developments that threaten to eventually affect the Indian economy. Despite the adverse implications of global factors on India, RBI is likely to continue with its policy of increasing rates in the near future as the domestic inflation rate will increase for a while longer. The second round impact of end-June's increase in the price of diesel is expected by economists to show up over the next couple of months, pushing inflation higher.

The deterioration in the global scenario primarily on account of fears that the sovereign debt crisis in Europe may spread and the US economy may slip into recession may, however, begin to exert more influence on RBI's actions after September.

By the last quarter of 2011, a more comprehensive picture of the way in which the US Federal Reserve plans to respond to the country's economic situation may be apparent. If the US Fed chooses to go through the third round of expanding its balance sheet to revive the economy (QE 3), RBI's task of managing the "impossible trinity" - an independent monetary policy, partly managed exchange rate and a liberalized capital account - would become more challenging on account of a part of the newly created liquidity finding its way into India. At that point, global developments may have a greater influence on monetary policy as compared to domestic factors.

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For the moment, RBI's 26 July monetary policy statement is likely to be the dominant influence. It emphatically stated that RBI's foremost priority today is to rein in inflation, and the thrust of monetary policy would be in the direction of meeting this objective. On Friday, Subir Gokarn, RBI's deputy governor, who was in Delhi for a meeting, repeated the message of the July policy on the central bank's determination to combat inflation.

June factory output data, as measured by the Index of Industrial Production (IIP), was driven primarily by a 10 per cent growth in manufacturing. IIP has been a volatile indicator of economic performance. Since the beginning of the last financial year, IIP has ranged between 13 per cent and 4 per cent. According to Gokarn, RBI typically juxtaposes IIP with other indicators before it reaches a conclusion on the state of economy.

More than the growth in IIP, the strength of consumer demand in India appears to be driving monetary policy. As the 26 July policy and the subsequent interaction of RBI governor, D Subbarao, had with the media indicated, the central bank feels consumer spending will remain robust. Consequently, it has used interest rate as the primary tool to pull back demand and, thereby, lower the price level in the economy.

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The next policy announcement is scheduled for September 16, when the central bank is likely to announce its 12th interest rate increase since March 2010. The primary policy rate, that is, the repo rate stands at 8 per cent. Repo rate is the rate which RBI lends money to banks.

The deterioration in the global scenario, which includes last week's unprecedented lowering of US's long-term rating by a notch to AA+ by Standard & Poor's, has led to mixed conclusions about the direction of monetary policy.

For instance, two research reports released after Friday's factory output data reached different conclusions. Deepali Bhargava, economist at ING Vysya Bank, wrote she expected RBI to hike repo rate by 25 basis points (one basis point is one-hundredth of a percentage point) in its September policy announcement.

Deutsche Bank's research report, on the other hand, concluded the "probability of a rate hike in September has declined considerably."
Subbarao, who was granted a two-year extension as governor earlier in the week, would probably view recent developments with a sense of deja vu. A few days after he was appointed governor in 2008, Lehman Brothers collapsed and the world changed. The extension comes in the backdrop of a marked increase in the challenge of being a central banker in a relatively fast growing emerging market.