Adequate response: on the RBI and inflation

After months of waiting and watching, the Reserve Bank of India (RBI)’s Monetary Policy Committee (MPC) has decided to act to try to rein in rising inflation. Its decision to raise interest rates by 25 bps seemed increasingly inevitable. The RBI now projects retail inflation at 4.9% in Q2, higher than its August projection of 4.7%. This is set to rise in Q3 to 6% before easing marginally to 5.7% in Q4. Global oil prices have again crossed $100 a barrel following a brief reprieve. India’s oil marketing companies, likely following government instructions, have held off on passing most of this increase on to consumers. However, they cannot withstand such fiscal pressures forever. The impact of higher crude prices has been bad enough, but higher petrol and diesel prices will likely send inflation spiralling. Simultaneously, a deficient monsoon is pushing up food prices and will continue to do so for the rest of the year. When supply-side factors are the primary drivers of inflation, an interest rate hike can only have second-order and largely marginal effects on inflation. In such a scenario, the signal sent by the MPC becomes as important as the actual action. The MPC has used this latest policy review to attempt to dampen inflation expectations, an important area of action. The expectation of high inflation in the near future can often become a self-fulfilling prophecy, independent of the factors driving prices up.

A 25 bps interest rate hike is a careful nudge rather than an inevitably ineffectual bludgeon. The fact that the MPC has changed its stance to ‘calibrated tightening’ from ‘neutral’ is the bigger signal. The question no longer is whether the RBI will hike rates in its next meeting in December, but by how much. The message from this stance change is that the central bank will use all the tools at its disposal to keep inflation in check. The RBI also clearly thinks that the economy can withstand such tightening. It has revised upwards its GDP growth forecast for 2026-27 to 7.1% from the 6.7% projected in August. That said, all economic agencies have, even before interest rates were hiked, been predicting a slowdown in the second half of the year. The growth-inflation trade-off will again test the RBI’s deftness. Higher interest rates may also pause the ongoing exodus of Foreign Portfolio Investors (FPIs), giving the RBI some exchange rate-related breathing room. The central bank has done what it can on inflation so far. The onus is now on the government. It has several tools to control food inflation, such as strategic buffers, import and export controls, anti-hoarding measures, and open market operations. Those need to be used more effectively.