By R Jagannathan
Governor Duvvuri Subbarao's third quarter review of monetary policy will be noted more for what he did than what he really said.
The markets, and surely the finance minister, will applaud his repo and cash reserve ratio cuts of 25 basis points (0.25 percent), but the underlying message on inflation is less comforting.
Reading between the lines, what Subbarao said was not that inflation is now less of a worry than growth, but that we may now have a new normal for inflation. (Read the policy statement and the Governor's remarks here and here)
The new normal may be somewhere around seven percent. Though the Reserve Bank of India (RBI) is still talking of containing "perceptions of inflation in the range of 4.0-4.5 percent," in practice it does not appear to be as hopeful of achieving anything close to that this year or the next.
In order to justify the CRR and repo rate cuts, the Governor did announce a downward revision in "baseline WPI inflation projection for March 2013 from 7.5 percent to 6.8 percent," but his real expectations are wrapped differently in another paragraph which reads: "However, further moderation in inflation going into the next fiscal year is likely to be muted as the correction of under-pricing of administered items is still incomplete and food inflation remains elevated. Accordingly, the setting of monetary policy has to remain sensitive to these conflicting pressures and attendant risks."
Further, he says: "With headline inflation likely to have peaked and non-food manufactured products inflation declining steadily over the last few months, there is an increasing likelihood that going into 2013-14, inflation will remain range-bound around the current levels."
Words like "muted" and "range-bound" are code for inflation staying high.
Nor is the Governor under any illusion that inflation is currently coming down for the right reasons. In fact, he clearly says that it is the slowing economy that is denting inflation, not corrective fiscal action. He said: "An environment of slower growth and excess capacity in some sectors suggests that inflation has come off its peak."
But further falls will depend more on luck and many ifs and buts. He said: "However, it (inflation) is expected to be range-bound around the current levels due to persisting food inflation, the pass-through of diesel price adjustments over the next several months and the possibility of adjustment in other administered prices. If international commodity prices, including the price of crude, further decline, they should cushion the phased increase in diesel prices, to the extent they are not offset by exchange rate movements."
Effectively, he is saying that inflation is going to stay high barring miracles like a drop in international commodity prices, especially crude, but even this depends on exchange rate movements (i.e. a stable rupee).
A real fall in inflation needs several levels of action by the government. "A sustained reduction in inflation pressure is, however, contingent upon alleviation of supply constraints and progress on fiscal consolidation. This will also help mitigate the cost-push pressures stemming from the surge in wages."
The real Subbarao statement should thus read: If crude prices ease, and if supply side improvements materialise, and if fiscal correction happens, and if the rupee stays stable, and if the wage spiral is contained, inflation may ease.
That's five unstated ifs for a maybe on inflation easing.
However, the conclusion that six-seven percent inflation is probably going to be the new normal comes not only from the governor, but the markets as well.
#1: Banks expect money to remain tight. On Monday, a day before the monetary policy, ICICI Bank and Axis Bank actually increased deposit rates even though a rate cut was expected. Now, why would canny private banks do that unless they expect credit demand to surge ahead of deposit growth?
#2: The underlying credit demand seems to be at variance with the slowdown story. RBI data show that as at the end of December 2012, deposits were growing at 11.1 percent while credit grew at 15.1 percent. But the incremental credit-deposit ratio was 102 percent. That is, for every additional Re 100 raised as deposits credit is Rs 102. This explains why private banks are raising deposit rates when the RBI is cutting rates.
#3: Recent tax-free bond issues are flopping. Tax-free bonds offer pre-tax yields well above bank fixed deposit rates, but most recent issues have failed to collect their targeted amounts. The India Infrastructure Finance Company Ltd, which set out to raise Rs 10,000 crore via tax-free bonds, managed to raise about Rs 2,892 crore due to coupon rates being below expectations. Most investors went for the 20-year bond due to higher yields, when shorter tenure ones should have been selling better.
Not only the RBI, even the signals coming from markets and investors suggest that inflation ain't coming down anytime soon. We should look at seven percent as the new normal in inflation.