Easing up

Dip in inflation numbers could pave the way for a rate cut. But the rupee will need to be watched

Inflation based on the wholesale price index declined to 4.9 per cent, below the 5 per cent mark. This good news came soon after the numbers for consumer price inflation had declined to 9.4 per cent last week, clearly below the 10 per cent mark. These inflation numbers pave the way for an easing of monetary policy. The RBI may still be cautious, and wait and see if the inflation numbers continue to dip, but the probability of a rate cut is higher when inflation is lower.

There are broadly two factors responsible for lower inflation. On the domestic front, lower GDP growth has resulted in lower demand. Investment demand has seen a sharp decline, consumption growth has moderated, exports are growing more slowly and government expenditure growth has contracted sharply in the last six months. These factors have contributed to slower growth in demand and thus a decline in inflation. The decline in WPI inflation, on the other hand, is largely a consequence of the global slowdown and the resulting decline in demand for commodities. This has happened both because of the recession in the advanced economies as well as the slowdown in China. A reduction in infrastructure investment in China has contributed to the reduction in the demand for commodities. In addition, lower price of oil has contributed to the decline. Looking ahead, one of the risks for India on the inflation numbers would be the exchange rate of the rupee. If the rupee remains at its current levels, there is less likelihood of inflation rising.

At present, the rupee is being held up by foreign investor sentiment about India. Both FDI and FII have continued to be strong. Even while difficulties with investment had led us to become despondent, for foreigners, India has remained a strong investment destination. This is both due to a long-term view of India and the hope that the country will come back on track to a high growth path, and because India looks better than many other countries today. Even at a sluggish 4.5 per cent GDP growth, it is better than countries that have dipped even more. If, due to unforeseen developments global events, domestic political turmoil or a credit ratings downgrade there is a change in the sentiment about India, there is a risk that foreign capital will not come in. This would mean that the rupee could depreciate, pushing up prices of tradables. Though in the long run, it may be argued that a depreciation may be useful for exports and correcting the current account deficit, in the short run, it may be disruptive for a path of easing monetary policy.

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