Wednesday, May 4, 2011

A tale of two central banks: RBI and RBA

India has stepped up its inflation fight with a 50bp increase in the repo rate to 7.25%. The market had been anticipating a 25bp increase. In Australia, the RBA left rates unchanged at its May meeting.

In India the break from the pattern of a series of 25bp increases in the repo rate is a tacit admission from the Reserve Bank of India (RBI) that they are struggling to get in front of the inflation problem. In the accompanying statement from the RBI, they admit they have “systemically under-predicted year-end inflation during 2010/11”. In January they had expected the rate of increase in the Wholesale Price Index (WPI) to fall to 5% by March – the number printed at 9%.

The problem for the RBI is that core inflation has got a way on them and economic activity remains strong. The annual rate of increase in core wholesale prices (using the manufacturing WPI) is currently running at 6.2% and growth in GDP is forecast to slow only modestly to 8.0% this year. That makes the (unofficial) WPI expectation of 6% by March 2012 a tad optimistic

Understandably then the tone of the RBI statement was more hawkish than previously. Further tightening seems a done deal. A repo rate of 8-8.5% by the end of the year is not out of the question.

Meanwhile, the Reserve Bank of Australia (RBA) has left interest rates unchanged at 4.75%. This was widely expected.

The RBA has to balance a number of factors: a core inflation result for March that surprised on the upside, the short- and medium-term impacts of the recent natural disasters, the rapid appreciation of the AUD, significantly higher terms of trade boosting nominal national income, and a trend decline in the unemployment rate that, if continued, will soon begin to assert upward pressure on wages.

While some of those factors are clearly offsetting, we believe the RBA was right to assume a more hawkish tone by asserting that core inflation is passed the low point in the cycle. At the same time, they are anticipating GDP growth to be above trend in the medium term. That seems to be a recipe for tighter monetary policy.

The RBA is, however, in the fortunate position of having done a reasonable amount of tightening work already. The current 4.75% level of the cash rate is 175bp above the GFC low of 3%. We think the RBA will start to tighten again in the next few months with the cash rate likely to be 5.5% by year-end.