After the rate hike | Business Standard Editorials

Clipped from: https://www.business-standard.com/article/opinion/after-the-rate-hike-122060500827_1.html

Policy will depend on RBI’s inflation projection

Market expectations from the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) have changed dramatically over the past few weeks. The rate-setting committee increased the policy repo rate by 40 basis points in an off-cycle meeting in May, which was a clear attempt to make up for the lost time. As several commentators have argued, the central bank is behind the curve in withdrawing monetary accommodation. The inflation rate based on the consumer price index (CPI) inched up to 7.78 per cent in April — nearly an eight-year high. Meanwhile, wholesale price index (WPI) inflation is in double digits for over a year. Although the RBI is mandated to target CPI inflation, sustained double-digit WPI inflation indicates the kind of price pressure the economy is facing.

Given the inflation condition, the MPC is widely expected to raise the policy rate by 50 basis points. It is also clear that this week’s rate hike will be only the second in a series. The minutes of the May policy meeting and communication from the RBI show that it has shifted focus to containing inflation. External MPC member Jayanth Varma, for instance, in his remarks noted that more than 100 basis points of rate increase would need to be carried out soon. Meanwhile, RBI Governor Shaktikanta Das said: “Waiting for one month till the June MPC would mean losing that much time while war-related inflationary pressures accentuated … it may necessitate a much stronger action in the June MPC which is avoidable.”

While the rate hike is a given, the markets would want to see the inflation and growth projections of the RBI. The global economy is expected to slow further, partly because of the monetary policy response to contain inflation, and it remains to be seen to what extent the RBI revises its growth projection. As of now, it expects the Indian economy to expand by 7.2 per cent in the current year, and that will be driven partly by the weak base of the first quarter of last fiscal year. However, it would have to significantly increase its inflation projection. Monetary action in the coming months will depend on the expected inflation outcomes. Several economists in the private sector expect the inflation rate to remain above the tolerance band in the current year.

In such a scenario, the average inflation rate will remain outside the tolerance band for three consecutive quarters and would be treated as a failure to attain the target. According to the law, the RBI will thus need to report to the Union government as to why it failed and what action it intends to take, along with giving an estimated time period by when the inflation target would be achieved. This would put enormous pressure on the central bank, forcing it to tighten monetary conditions and raise the policy rate at a faster pace. A sharp increase in interest rates could affect the ongoing economic recovery. The latest numbers showed that the Indian economy has barely crossed the pre-pandemic level of real output on an annual basis. However, the RBI is now left with very little choice after underestimating inflationary pressures for a while. From a medium- to long-term perspective, it is important to maintain price stability. Ignoring inflation for too long can increase risks for macroeconomic stability and damage longer-term growth prospects.

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