5 reasons why it has become imperative for RBI to hike rates
All these factors threaten the sanctity of the 4% inflation target, which the Reserve Bank of India (RBI) wants to maintain at any cost
Mumbai: The environment for monetary policy has changed dramatically in recent months. In the last few years, inflation has been kept down due to a combination of several factors: falling crude oil and commodity prices, which kept input prices for companies under control; low minimum support prices for crops, which kept food prices contained; excess capacity in industry, which kept a lid on industrial prices; and lower government fiscal deficits as a percentage of gross domestic product. But each of these restraints on inflation has reversed recently. Here are five reasons why the Reserve Bank of India (RBI) needs to raise its policy rate at its meeting this week:
Core comes to the fore, again
A central bank worth its salt would always focus on pockets where demand conditions harden persistently. Enter core inflation, RBI’s permanent foe in inflation management. Core inflation—which excludes food and fuel—is edging up every month. It is now far above 5%, and considering the stickiness of it, a threat to RBI’s 4% target. Even the core core inflation, which removes transportation and gold, is also firming up. As the Indian economy recovers and demand firms up, producers will be able to pass on increases in costs.
Minimum support, maximum inflation
The hike in minimum support prices (MSP) for agriculture this time is steep, compared with historic averages. Granted that the impact of MSP will depend on how much the government procures. Even so, the lull in food inflation would disappear soon once the MSP kicks in. And this is not far. The language of RBI leaves no doubt that higher MSPs are a danger to inflation.
Oil is simmering if not boiling
Global crude oil prices are a big swing factor in the behaviour of domestic inflation, something RBI has also indicated. Oil prices have stabilized since the June policy. But this should not cloud the fact that oil prices are far above the comfort level of the central bank. Moreover, there is no guarantee crude will continue to behave, as geopolitical tensions continue. Global growth continues to be robust, which will mean increased demand for oil. And with China relaxing its monetary policy, prices of metals should also start to climb.
Mind the gap
Notice the significant shift in language in the June policy, with the most dovish member of the monetary policy committee, Ravindra Dholakia, conceding that the output gap—the gap between the level of economic activity and its potential—is closing. That points to two things—one, capacity is becoming a constraint, which means businesses will raise prices when faced with strong demand; and two, the economy is strong enough to absorb a rate hike.
Vote for populism
The Lok Sabha elections in 2019 make it hard for any government to ignore populist measures. Such measures can be tempered by the central government, but states may be hard-pressed to avoid them, especially if monsoon plays truant. Already, 10 states have received scanty rainfall, making a case for farm loan waivers. Fiscal prudence is unlikely to be a top priority and RBI needs to pre-empt this. Ergo, a rate hike.
All these factors threaten the sanctity of the 4% inflation target, which RBI wants to maintain at any cost. Failure to do so would lead to a rise in inflation expectations, which had started to move up, as the last RBI survey has shown. In June, the central bank hiked its inflation forecast to 4.8-4.9%. If there is even a slim chance that retail inflation could breach this range, RBI would be better off hiking now.