Manish Sonthalia, Fund manager – PMS, Motilal Oswal Securities

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“The availability of sugar will improve and the prices will come down within a month.”

Sharad Pawar, Agriculture minister, after the government took a series of steps to curb soaring food prices

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“Food inflation is rapidly becoming the key policy challenge as the purchasing power of poor households is being eroded.”

Tushar Poddar, Economist, Goldman Sachs

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“We shall sustain this positive trend (in exports) in the current quarter.”

Anand Sharma,
Trade Minister, after December exports rose to a 15-month high

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It is time. After warning about inflation pressures for months, Reserve Bank of India governor D Subbarao is all set to take action on that front in the central bank’s monetary policy review on January 29. The firm roots that economic recovery seems to have taken are also supporting such action.

Over the past fortnight, news on the economy has been highly encouraging. Industrial production in November surged to 11.7 per cent from a year ago, the highest in two years and follows a 10.3 per cent expansion in October. December exports jumped to a 15-month high to $14.6 billion, representing the first month-on-month increase in 14 months. Bank credit (non-food) growth sprung a further surprise, soaring by Rs 78,000 crore or 14 per cent from a year ago for the fortnight ending January 1. While a fair amount is attributed to ‘window dressing’ to prop up quarterly performance, most experts forecast credit will pick up from here on. And there were other bits of good news to suggest that the economy was healing quickly. Auto sales – an indication of consumer demand – roared ahead by 68 per cent in December from a year ago, while steel and cement prices – an indication of investment demand – are expected to continue rising in coming months. Cement dispatches have also risen by about 10 per cent in the December quarter.

The major irritant remains inflation, which has also jumped. The wholesale-price index in December rose by 7.3 per cent from a year earlier, following a 4.78 per cent gain in November. Still, it was marginally lower than market expectations. Experts say the time to act against soaring inflation snuffing out growth is now. “While we have seen positive signs on the economy since June, the worry was whether growth was so fragile for even a modest rate hike to be a spoke in the wheel of recovery,” says Atsi Sheth, economist with Macro Sutra, a research outfit in Mumbai. “Now we know the answer to that – growth is strong enough.”

Now that growth is good enough, experts believe the focus of the RBI will shift to battling inflation more strongly. Of course, a large part of the rise in prices all through last year has been because of sizzling food prices, caused by a poor summer crop season and global production shortfalls in agricultural items such as sugar. Improving supply is not exactly something the RBI can do with interest rate changes, but most economists believe that to prevent soaring food prices from having a spill-over effect onto other industries, action needs to be taken, else expectations of general inflation across the economy rise. Besides, even non-food inflation is starting to flash some warning lights. Prices of several commodities such as industrial metals and energy (key inputs across industries) have already risen substantially – and predicted to keep up the march in 2010. Meanwhile, demand is also recovering, giving producers some pricing power again. “Pricing power is gradually visible in certain sectors like textiles, chemicals, cement and steel,” says Shubhada Rao, chief economist with Yes Bank. “Higher input costs and improved pricing power for producers are combining to push overall prices higher. This, combined with a sustained rise in food prices, feeds into higher wage expectations and is keeping inflation expectations elevated.”

There’s almost complete consensus on how Subbarao will hose down inflation: one, the central bank will take steps to mop up excess liquidity and two, tinker with interest rates, ascending from low-impact to high-impact rate hikes. Only step 1 is expected in the current policy review. “The markets have already discounted a 50 basis point hike in the cash reserve ratio (the percentage of deposits banks must keep with the central bank),” says Satyajit Kanjilal, CEO of Forexserve, a Mumbai-based foreign exchange and treasury consultancy. There’s an outside chance, say experts, that the reverse repo rate, currently at 3.25 per cent, could be raised as well. A reverse repo facility allows banks to lend to the central bank for the short term and indicates the extent of surplus liquidity in the system. Currently, about Rs 80,000 crore is parked in reverse repos.

The 25-50 basis hike in CRR is not expected to affect liquidity much, but as Macro Sutra’s Sheth says, “it will be a signal to the markets that the RBI is now comfortable with growth.” A direct attack on interest rates will only come later (perhaps by March), because credit offtake, barring the eye-popping numbers of the January 1 fortnight, is still sluggish compared with previous years.

That’s not all. There’s also the matter of capital inflows. Last year, more than $17 billion of foreign investment flooded Indian equities, buoyed by relatively strong growth prospects across Asia compared with the developed world and super-low interest rates. The rupee has already gained 8 per cent in the past nine months and as Forexserve’s Kanjilal says, “more inflows are on the anvil”. He expects the rupee to move towards the 44.50 mark against the dollar by March. Demand for the local currency increases when demand for domestic stocks and bonds rises because investors need local currency to pay for their purchase of these assets.

An interest rate hike will only further fuel inflows and push up the value of the rupee against major currencies. But that could pinch exports, which have only begun to recover. “While inflation is a concern right now, capital inflows and its impact on the rupee will be the next big worry,” says Macro Sutra’s Sheth.

The job of a central bank, it seems, is never done.