To hike or not to hike? That is the question before the Monetary Policy Committee (MPC) when it reviews policy later this week. The case for tighter monetary policy is not insignificant. The rupee has weakened nearly 6% this year and inflationary pressures are building as crude oil prices show little sign of easing. Yet, the case for holding rates is stronger.
Persistently high oil prices threaten to undermine growth momentum by squeezing household incomes and raising business costs. On balance, therefore, a hike in the repo rate from the current 5.25% appears unlikely for now. Some argue that higher interest rates could help arrest the rupee’s slide. Experience suggests otherwise.
During the taper tantrum of 2013, rate hikes did little to stabilise the currency. Using monetary policy primarily to defend the exchange rate risks inflicting unnecessary damage on growth at a time when India is seeking to attract investment and capital flows. The Reserve Bank of India (RBI) is also unlikely to react to currency weakness alone when the underlying pressures stem largely from external factors.
More importantly, the full inflationary impact of higher crude prices has yet to show up in consumer prices. Retail inflation eased to a lower-than-expected 3.5% in April, with core inflation continuing to soften. However, fuel prices have risen by about 7.50 a litre since May 15, pushing up transportation costs across the economy.
CRISIL estimates the direct impact on consumer price index inflation at around 35 basis points. Additional fuel price increases of8-10 a litre may be required to reduce the losses of oil marketing companies, potentially adding another 35-40 basis points to inflation.
Producers are also beginning to pass on higher input costs to consumers. Combined with the risk of El Niño affecting food production, economists now expect inflation to average 5.5-5.6% this year.
The RBI will therefore need to revise its FY27 inflation forecast upward from the current 4.6%, perhaps by 30-40 basis points, while also raising its oil-price assumption to around $95 a barrel from $85. Such revisions would signal that the central bank remains vigilant and prepared to act if inflation expectations become unanchored.
At its April policy review, the RBI warned that a supply-side shock from higher crude prices could eventually generate broader demand-side inflationary pressures. So far, demand has held up reasonably well, with automobile sales in May remaining robust. In any case, higher crude oil prices, elevated freight costs, and the risk of weather-related disruptions to food supplies are factors that monetary policy can do little to address.
Raising interest rates may dampen borrowing and investment, but it will not lower the price of imported crude or increase the availability of food grains. If anything, an aggressive policy response risks compounding the problem by slowing economic activity.
The second-round effects of inflation are still unfolding, and a clearer picture of consumer spending trends is likely to emerge only over the next few months. The central bank will be reluctant to jeopardise growth when many sectors are already grappling with fuel shortages and rising input costs.
It may even trim its growth forecast modestly from the current 6.9%. While higher inflation and oil-price projections could appear hawkish at a time when benchmark bond yields remain above 7%, the RBI must reassure markets that liquidity will remain adequate. Preserving financial stability while keeping policy options open may be the most prudent course for now.
To hike or not to hike? That is the question before the Monetary Policy Committee (MPC) when it reviews policy later this week. The case for tighter monetary policy is not insignificant. The rupee has weakened nearly 6% this year and inflationary pressures are building as crude oil prices show little sign of easing.
Yet, the case for holding rates is stronger. Persistently high oil prices threaten to undermine growth momentum by squeezing household incomes and raising business costs. On balance, therefore, a hike in the repo rate from the current 5.25% appears unlikely for now. Some argue that higher interest rates could help arrest the rupee’s slide. Experience suggests otherwise.
During the taper tantrum of 2013, rate hikes did little to stabilise the currency. Using monetary policy primarily to defend the exchange rate risks inflicting unnecessary damage on growth at a time when India is seeking to attract investment and capital flows. The Reserve Bank of India (RBI) is also unlikely to react to currency weakness alone when the underlying pressures stem largely from external factors.
More importantly, the full inflationary impact of higher crude prices has yet to show up in consumer prices. Retail inflation eased to a lower-than-expected 3.5% in April, with core inflation continuing to soften. However, fuel prices have risen by about Rs 7.50 a litre since May 15, pushing up transportation costs across the economy.
CRISIL estimates the direct impact on consumer price index inflation at around 35 basis points. Additional fuel price increases of Rs 8-10 a litre may be required to reduce the losses of oil marketing companies, potentially adding another 35-40 basis points to inflation. Producers are also beginning to pass on higher input costs to consumers.
Combined with the risk of El Niño affecting food production, economists now expect inflation to average 5.5-5.6% this year.
The RBI will therefore need to revise its FY27 inflation forecast upward from the current 4.6%, perhaps by 30-40 basis points, while also raising its oil-price assumption to around $95 a barrel from $85. Such revisions would signal that the central bank remains vigilant and prepared to act if inflation expectations become unanchored.
At its April policy review, the RBI warned that a supply-side shock from higher crude prices could eventually generate broader demand-side inflationary pressures. So far, demand has held up reasonably well, with automobile sales in May remaining robust.
In any case, higher crude oil prices, elevated freight costs, and the risk of weather-related disruptions to food supplies are factors that monetary policy can do little to address. Raising interest rates may dampen borrowing and investment, but it will not lower the price of imported crude or increase the availability of food grains. If anything, an aggressive policy response risks compounding the problem by slowing economic activity.
The second-round effects of inflation are still unfolding, and a clearer picture of consumer spending trends is likely to emerge only over the next few months. The central bank will be reluctant to jeopardise growth when many sectors are already grappling with fuel shortages and rising input costs.
It may even trim its growth forecast modestly from the current 6.9%. While higher inflation and oil-price projections could appear hawkish at a time when benchmark bond yields remain above 7%, the RBI must reassure markets that liquidity will remain adequate. Preserving financial stability while keeping policy options open may be the most prudent course for now.