First, the clarification: there is no official link between RBI’s policy rate and headline CPI inflation. The central bank continues to anchor inflationary expectations to headline WPI inflation, with the medium-term target of around 5%. However, in the current market environment, most analysts believed that CPI inflation had increasingly assumed that role while its formal adoption was being debated by RBI’s committee on a new monetary policy framework.
Much of this belief was attributed to the new Governor’s stated views on inflation, monetary policy actions of twice raising the repo rate by 25 basis points and formalisation of the process to issue CPI-inflation indexed certificates. Market interpretations of these developments were straightforward: The Governor was focused on headline CPI inflation and was trying to develop a link with its policy rate. Here also the Governor had extended an unequivocal clue—that savers must get a positive real return. If that is so, analysts rationalised, RBI’s policy rate should at least match up to headline CPI inflation, if not more. And if CPI inflation had to be killed and inflationary expectations to be moderated, which again are highly correlated to CPI, interest rates must go up a few notches more!
Not surprisingly, there was a near-consensus in the market that policy rates would go up; the only issue was whether the central bank would continue with a few more baby steps of 25bps to catch up or go all the way with a few big hikes. While most ruled out the latter and factored in a few more hikes of 25 bps each, none doubted the resolve of the new Governor to take inflation head on and do whatever it would take to rein in persistent price rise. Further buttressing their belief, RBI had produced the first official CPI-inflation forecast in its end-October policy review; one more solid step in the process of formal transition to CPI inflation as its policy anchor.
What, however, surprised analysts was the post-policy interaction with the Governor. To a question on whether RBI would raise the policy rate any further, given the higher, end-of-the-year CPI inflation forecast, the Governor replied the central bank was done with its policy rate hikes, which had factored in this projection; he further clarified RBI would now observe inflation as it unfolded going forward and would only act if the out-turn was significantly different than predicted.