As expected, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) maintained the status quo on interest rates during its review meeting in October and retained its stance of withdrawing accommodation. The current cycle peaked with the repo rate hike in February. The RBI prefers higher rates for longer periods for both domestic and external reasons.
While external factors have a bearing, domestic ones matter more. Unanticipated risks to inflation — quite beyond the control of policymakers — started manifesting at the beginning of the second quarter of this fiscal in the shape of the red-hot prices of tomatoes and other food items. While that pain from vegetables has subsided, another has reared up in volatile and rising crude oil prices. The RBI Governor also noted that the transmission of past rate hikes — 250 basis points since May 2022 — to bank lending and deposit rates remains incomplete. These factors have nudged the MPC to hold its stance of “withdrawal of accommodation”.
The continuation of hawkish monetary policies by systemically important central banks, particularly by the US Federal Reserve, and the rise in crude oil prices have been external triggers. Global central banks have been on their toes since Covid-19 struck. First, they had to ease monetary policy rapidly to fight an economic collapse, and then hike repeatedly to tame inflation. This script has played out more in advanced economies than in emerging markets. For instance, policy rates have risen only 250 basis points in India in the current cycle compared with 525 basis points in the US. In the developed world, monetary policy is at a delicate juncture — tighten too much and tip the economy into a recession; less-than-optimal tightening and inflation gets entrenched.
Monetary policy acts with a lag, first on growth and then on inflation. In the US, given the offset from a loose fiscal policy, the transmission to growth and inflation has been slow. This is why S&P Global believes a slowdown has been postponed in the US, not averted. Although inflation is softening now, the headline and core prints remain above target.
Central banks in the advanced countries could likely err on the side of caution and keep rates higher for longer given the challenges in inflation control. Odds today are in favour of another rate hike by the Federal Reserve and the European Central Bank before the process of holding rates at elevated levels for a longer period begins. The upshot of this stance is the US 10-year treasury yield soaring to 4.8 per cent, the highest in 16 years. This is attracting capital to the US and away from the emerging markets, and strengthening the dollar. The rupee, not surprisingly, has been under the pump.
To its credit, India’s growth has held strong despite costlier crude oil, weakening rupee and pressure on food inflation from an erratic monsoon. Supply shocks amid healthy growth will keep the RBI cautious. It has already raised its inflation forecast for this fiscal to 5.4 per cent from the 5.2 per cent made in June.
While inflation in cereals has been high for a while, the tomato-led surge in vegetable inflation spiked the consumer price index print to 7.4 per cent in July. Since then, fresh arrivals have corrected vegetable prices, and crushed those of tomatoes, causing angst at farms. Consequently, August inflation softened to 6.8 per cent. We expect September inflation to fall further. RBI’s inflation for the second quarter at 6.4 per cent implicitly assumes around 5 per cent inflation in September. We have raised our inflation average forecast for this fiscal to 5.5 per cent from 5 per cent due to the jump in food inflation in July-September.
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The concern over cereals, pulses and spices inflation persists given their double-digit readings. To boot, overall kharif sowing is only marginally above last fiscal’s level and lags for pulses and jute. With El Niño conditions predicted till year-end, weather bears watching. The southwest monsoon also influences groundwater and reservoir levels for the rabi or winter crop, which is produced in largely irrigated areas. The current suboptimal reservoir levels also cast a cloud. According to the Central Water Commission, as on September 29, live storage at reservoirs was 82 per cent of the previous year’s corresponding levels and 92 per cent of the decadal average.
Despite the spike in headline inflation, policymakers could derive some comfort from the relatively benign fuel and core inflation — the headline print was almost entirely food-led. But crude oil prices have emerged as another potential risk. India is highly vulnerable here because around 85 per cent of its requirement is imported. Crude prices have been very volatile. If they rise and sustain at elevated levels, headline inflation can rise via direct and indirect effects of higher production and transportation costs. In addition, higher crude prices create upside risks for the current account and fiscal deficit, and a downside risk to growth. This is cause for vigil, not alarm. Global demand conditions are expected to weaken and are unlikely to provide upward thrust to crude oil prices. But geopolitics and supply squeeze can offset this. Crude prices have trended up this fiscal but have been quite volatile — swinging from over $95 a barrel to around $85 in the past few days. So, fingers crossed. Inflationary expectations, which are generally adaptive, have broadly remained anchored. IIM-Ahmedabad’s business inflation expectation survey for July suggests a slight increase in year-ahead business inflation and no change in the August survey. RBI’s household inflation expectation survey for September shows easing of consumer inflation expectations from double to high single digits.
The RBI has retained its GDP growth outlook at 6.5 per cent for this fiscal. CRISIL sees it at 6 per cent, compared with 7.2 per cent last fiscal for three reasons: Deepening global slowdown curbing exports, lagged impact of the series of domestic rate hikes manifesting and curbing consumption demand, and erratic weather and El Niño curbing agricultural growth. What’s more, persistent supply shocks, whether from food or fuel, can transmit to other parts of the economy and broadbase inflationary pressures. Ergo, the MPC is unlikely to take the scalpel to rates soon.
The writer is Chief Economist, CRISIL Ltd
