RBI likely to remain in pause mode on interest rate

Sanjiv Shankaran

Inflation, as measured by the wholesale price index, was 4.86 per cent in June 2013, the highest in three months, but within the central bank's comfort zone of 5 per cent. Despite the low headline inflation number, the Reserve Bank of India may not reduce its policy rate in the next monetary policy announcement scheduled for July 30 as the fallout of the rupee's battering in the foreign exchange market has not yet shown up in inflation data.

Inflation stayed within the RBI's comfort zone mainly on account of a fall in inflation of manufactured products to 2.75 per cent from May's reading of 3.11 per cent.  Inflation in manufactured products is a proxy for demand-side pressure on prices and is what RBI's monetary policy seeks to contain.

In the current instance, the deceleration in manufactured products inflation also reflects weakness in industry. Weak demand conditions have meant firms have lost the power to pass on input price increases to consumers.

For instance, the Index of Industrial Production (IIP) in May contracted by 1.6 per cent. Unlike similar readings in the recent past, all the significant sub-sectors of industry contracted in May. Basic goods, capital goods and consumer goods contracted, the first time this has happened since February 2009. It marks the extent of weakness in industry.

Despite the weakness in industry and overall economic growth in 2012-13 falling to a decade low of 5 per cent, RBI may be forced to refrain from lowering interest rates to stimulate demand. With both inflation and growth trending downwards, lowering interest rates would have been the typical course of monetary policy.

The rupee, which ended Monday close to Rs 60 against the US dollar, has depreciated almost 10 per cent since the beginning of 2013. The fall in the value of rupee has had a sharp impact on the extent of diesel subsidy provided by state-owned oil companies. From a little below Rs 3 per litre in April, the subsidy has increased to close to Rs 10. The subsidy has risen as it costs more to buy a barrel of oil in the international market - India imports about 78 per cent of its crude need. The fall in the rupee's value has more than offset a fall in the value of crude to a range between $100 and $105 a barrel.

There are two ways this will play out. Either the government bears the cost of increasing subsidy, which has a negative impact on the fiscal deficit. This, in turn, eventually pushes up inflation. Or else, oil companies relentlessly increase diesel and cooking gas prices to lessen the subsidy. Recent research by Crisil, shows that if the rupee remains weaker than Rs 58 per US dollar, it would completely offset the softening price trend of crude oil and metals in 2013-14.

If the rupee continues to hover around the Rs 60 mark, companies will pass on at least a part of their higher input costs to consumers despite weak demand. Weak demand will prevent a complete pass through.

These effects have not yet showed up in inflation data. Therefore, RBI may sit tight for a while longer before it nudges interest rates lower later in the year as it cannot ignore the economic slowdown beyond a point.