RBI takes the right step

RBI takes the right step

The Reserve Bank of India (RBI) has taken an aggressive stance in countering the key macroeconomic risk to the Indian economy today: inflation. The central bank raised both the repo and reverse repo rates by 50 basis points (bps), exceeding the expected “calibrated" 25 bps hike.

This step must be welcomed and RBI commended for taking what is—in light of troubling data—the right step. A 25 bps increase would simply not have worked. By the time the effect of this small step worked its way, economic agents—firms and individuals alike—would have revised their inflation expectations upward. As Tuesday’s policy statement shows, RBI understood this point very well.

The central bank’s baseline projection for Wholesale Price Index (WPI) inflation for March 2012 is 6%. While this is a “comfortable" number, it is subject to six factors that still remain opaque. The first and foremost is “a significant suppressed component of inflation as the increase in crude oil prices has not been passed on completely"; second, the upward pressure on global crude prices; third, the combined effect of these two problems in swelling of subsidies and ultimately generating inflationary pressure; fourth, rising prices of industrial raw materials; fifth, the monsoon and its effect on agriculture and, in turn, on food prices; and finally, the possibility of cooling in demand pressures due to a moderation in growth.

In an ideal, rational, policymaking world, problems such as readjusting fuel prices in response to higher international prices would not be an issue. In the messy world of Indian politics, it is. Chances are the baseline projection may be breached. Estimates vary, but the 6% figure could overshoot by 100-150 bps. Once inflation touches the 7-7.5% level, rising inflationary expectations could return to haunt RBI.

What should be done to avoid that adverse outcome? Two steps need to be taken. One, RBI needs to continue with its remaining rate hikes, preferably front-loading them. Two, the government needs to undertake substantial fiscal consolidation. Doubts over the first factor should be discounted. The real worry is on the second count.

It will not take long before the country knows if the government is serious about fiscal consolidation. The politically feasible window for increasing administered prices of fuels will remain for the next six weeks. If prices are raised quickly, then inflation could peak in the coming months and then cool thereafter. After that, as elections in Uttar Pradesh—due next year— approach, the government’s room for manoeuvre would be much restricted.

Is 6% inflation too optimistic? Tell us at views@livemint.com