The six-member monetary policy committee of the Reserve Bank of India had a difficult job on hand in an uncertain environment. While headline retail inflation continued to surge above the RBI’s target, the nascent economic recovery was showing signs of slowing, with industrial production growth in May slipping to a seven-month low. Most indicators related to inflation did suggest a rate hike, but there were equally compelling reasons for the central bank to avoid a back-to-back interest rate increase. In the end, however, the MPC decided 5:1 to stick to the path of maintaining the 4 per cent inflation target and increase the interest rate by 25 basis points. What perhaps helped the MPC in reaching this decision was the increased output of the eight core industries in June, which suggested that the economic recovery is back on track. This made the job of focusing on containing headline inflation easier.
The RBI had revised upwards its inflation projection for the second half of the current financial year to 4.8 per cent in its June review. There were fresh worrying signals this time. The June round of the RBI’s survey of households reported a further uptick of 20 basis points in inflation expectations for both the three-month and one-year ahead horizons as compared to the last round. Moreover, the inflation projection for the first quarter of the next financial year, that is 2019-20, has been pegged at 5 per cent. Considering that monetary policy transmission happens with a significant lag, the MPC did not want to be behind the curve and decided to raise the rate now to pre-empt an inflationary build-up.
The RBI is also aware of the fact that the higher minimum support prices for the kharif season, which are much larger than the average increase seen in the past few years, will have a direct impact on food inflation and second-round effects on headline inflation even though there is considerable uncertainty about its exact impact. Besides, the impending election season can build up inflationary pressure by way of fiscal slippages as the government might be tempted to take populist actions. Monetary policy actions are always difficult during election time — a fact that might have encouraged the central bank to frontload the increases in rates. Given the volatility in global growth, trade tensions and possible currency wars, which Governor Urjit Patel highlighted in his post-policy interaction, there were several other risks on the inflation front. That means despite the “neutral” stance, the RBI has kept the door open for another rate hike before the end of 2018-19.
Mr Patel was clear that the central bank would remain an inflation-warrior when he said the two rate actions in June and August were to maximise chances of not drifting away from the 4 per cent target. Where does that leave India’s growth? The RBI appeared more sanguine about the economy’s prospects. It quoted improved foreign direct investment, deceleration of foreign portfolio outflows, robust capacity utilisation in manufacturing and broad-based pick-up in services growth to buttress its stand.