Even ahead of the 25-basis-point (bps) rate hike by the Federal Open Market Committee on Wednesday, rising and increasingly broad-based inflation at home, amid fairly strong growth momentum, provided sufficient reason for monetary policy to be tightened. Retail inflation in August hit 4.8% year-on-year, a far cry from the benign sub-3% levels at the start of the year. That is still well within the Reserve Bank of India’s (RBI) comfort zone, but there are signs that prices in some pockets are rising faster than before. Services are one such area, with relative softness giving way to firmer price pressures. What could really throw inflation off-kilter is the renewed surge in crude oil prices to over $100 a barrel, which has pushed the Indian crude basket to around $120-125 a barrel. With the crisis in West Asia worsening and Lindsey Graham’s Russia and Iran sanctions bill close to becoming a reality, India finds itself in a predicament. Supplies may or may not be severely disrupted, but the oil import bill can only get bigger, potentially compelling the government to resort to another round of petrol and diesel price increases. A hike of Rs 7.50 a litre, similar to the last round, could push inflation above 6%, making the central bank’s task considerably harder.
Pressure points are also emerging in the food basket as vegetables, cereals, and sugar become costlier; food inflation is nudging 6% even before the effects of a less-than-normal monsoon and El Niño have been fully felt. If headline consumer price index inflation (CPI) has not yet moved above 5% or become “generalised”, it is partly because companies have yet to fully pass on higher input costs to consumers, as reflected in the gap between non-food wholesale price index and CPI inflation. That the pass-through is under way can be seen in the rise in super-core inflation, which excludes the impact of precious metals. Clearly, price pressures are becoming more broad-based, and the Monetary Policy Committee (MPC) needs to take this seriously, particularly before inflation expectations become entrenched.
Even in the absence of a broad-based rise in prices, however, a recalibration of rates may be warranted. Core inflation is trending higher and should average a little over 4% this fiscal, while consensus estimates now peg headline inflation at 5.5-6% for the September-November period. Real interest rates, too, remain low. These factors have clearly not escaped the MPC’s attention. The minutes of the August meeting reflected a “hawkish hold”, somewhat at odds with the dovish tone of the policy statement and RBI commentary. Importantly, a recalibration need not be accompanied by a change in the policy stance — currently neutral — giving the RBI greater room for manoeuvre and allowing it to respond to incoming data.
The rate-hiking cycle is likely to begin with a 25-bps increase in October, followed by a similar move in December, with the objective of anchoring inflation expectations. Much as in other countries, money is set to become costlier in India too. That is unfortunate because it would make loans more expensive for individuals and small businesses. A higher cost of capital at a time when growth is set to decelerate — to about 7% this year — cannot be helpful. One hopes the plentiful liquidity in the system will keep banks’ borrowing costs relatively low, allowing lending rates to remain reasonable. If the growth momentum is to be sustained, credit needs to remain affordable.