It was a close call whether the Reserve Bank of India (RBI) would hike or not. In the end, it did hike and it was the right thing to do.

On the surface the economy appears to be slowing, industrial production growth has been on a declining bias, export growth has fallen five months in a row, non-oil imports fell sharply last month, the global economy, while not double-dipping, isn’t really showing any convincing sign of a sustained recovery, and India’s main engine of growth—corporate investment—hasn’t fired at all.

Added to all this, non-food manufacturing appears to have stabilized in the last three months and the only real concern seems to be food inflation, which has been very sticky and structural. And since monetary policy cannot influence food prices, why hike policy rates only to make firms even less reluctant to invest?

But look at the data differently. We have been running loose fiscal and monetary policies for the last two years now. The rest of the world is doing much more of the same. But the rest of the world, including China and the US, has substantial excess capacity. We don’t. And this combination has often ended in tears if persisted for long.

This year’s fiscal deficit will likely end around 5.2% of gross domestic product (GDP), much better than the budgeted 5.5%, and sharply down from last year’s 6.9% and well on track to reach the projected 4.8% target for next year. But compare apples with apples. Take away the one-off 3G licence sale and the deficit looks more like 6.7% of GDP. Suddenly this year’s fiscal consolidation looks apologetic and next year’s 4.8% target a tall order.

And despite the effective 3-percentage-point rate hike, policy rates are still negative at the current inflation rate. Food inflation has already turned structurally high as demand has outstripped supply across almost all categories. Non-food inflation is being driven by global commodity prices and tight domestic capacity. Even if the investment cycle turns up today, it will take at least 12-18 months before it becomes capacity and eases supply.

More importantly, persistently high food inflation has become entrenched in expectations and wages. RBI’s own survey suggests households expect inflation to be around 11%, not 5%, while input prices in the Purchasing Managers’ Index survey has been growing relentlessly in recent months as have all labour-intensive services in the Consumer Price Index basket. Looked at this way, the war on inflation is far from over, calling for continued tightening.

And so RBI took the middle path of hiking rates 25 basis points and calling for a temporary pause. One basis point is one-hundredth of a percentage point. Just a word of caution. The operative word here is temporary. The market seems to be assuming that this pause could be for long. All that this policy statement does is to spare a rate hike in the scheduled December mid-policy review. The January quarterly review is still up for grabs. Any sign that inflation may not reach 5.5% by end-March and rate hikes are back.

These are the author’s personal views.

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