India Raises Rates 25 BP

Last week, the new head of the Reserve Bank of India issued his first policy statement, raising rates 25 basis points while reducing some of the extraordinary measures put into place over the last few months to halt currency outflows.  While many news outlets reported this as a startling development, a sober look at the data would reveal this move was hardly controversial.  First, while inflation dipped in the earlier part of the year (4%-6%), it has since been rising, approaching the higher levels (7%+) seen last year.  Second, the head of the Bank is new, and he would want to establish his inflation fighting credentials for the markets specifically and the economy at large generally.  Seen in the light of these two facts, the move should have been anticipated.  For background on the India situation see these posts: here, here, here and here.

Here are some salient points from the points from the policy announcement:

On the domestic front, growth has weakened with continuing sluggishness in industrial activity and services. The pace of infrastructure project completion is subdued and new project starts remain muted. Consumption, while relatively firm so far, is starting to weaken even in rural areas, with durable goods consumption hit hard. Consequently, growth is trailing below potential and the output gap is widening. Some pick-up is expected on account of the brightening prospects for agriculture due to kharif output and the upturn in exports. Also, as infrastructure investments are expedited, and as projects cleared by the Cabinet Committee on Investment come on stream, growth could pick up in the second half of the year.

WPI inflation, which had eased in Q1 of 2013-14, has started rising again as the pass-through of fuel price increases has been compounded by the sharp depreciation of the rupee and rising international commodity prices. The negative output gap will exercise downward pressure on inflation, and the process will be aided as supply side constraints, especially relating to food and infrastructure, ease. However, the current assessment is that in the absence of an appropriate policy response, WPI inflation will be higher than initially projected over the rest of the year. What is equally worrisome is that inflation at the retail level, measured by the CPI, has been high for a number of years, entrenching inflation expectations at elevated levels and eroding consumer and business confidence. Although better prospects of a robust kharif harvest will lead to some moderation in CPI inflation, there is no room for complacency.