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Home / Opinion / Views /  The RBI has no option but to raise rates

Today, 5 August, the monetary policy committee (MPC) will announce its decision on the policy rate. It is expected to be raised by between 0.25 and 0.50 percentage points. Monetary tightening carries a growth sacrifice, but inflation permissiveness can be seriously destabilizing. The issue of course is how successful monetary tightening will be in curtailing inflation.

These decisions are being forced upon us while growth is faltering both globally and in India. A 26 July update to the April World Economic Outlook of the International Monetary Fund lowered growth forecasts for most countries, India included. Indian growth is forecast at 7.4% (for the current fiscal year—a recent exception for India from the IMF’s customary calendar years). The consensus among domestic analysts is even lower, at 7%.

Headline Indian inflation has headed upwards after October 2021, much before the Russia-Ukraine war, owing to the difficulties of gearing up the supply side post-pandemic. But it was the war-induced rise in the price of fuel oil that caused the jarring spike in March 2022, peaking in April at 7.8% year-on-year. Brent crude prices have remained volatile since then, but have softened since June. Domestically, a round of fuel tax cuts in May 2022 helped. Some loosening of global supply side blockages on fuel oil and gas may happen, although the recent halving of Russian gas supplies to Europe is not promising. Energy sourcing might become more broad-based with the possible reactivation of nuclear plants in Germany. Global prices of non-fuel commodities have fallen from their April peak, although fertilizer (we are one of the major world importers) has fallen only by 12%.

In India, we seem to be finally securing Russian oil and coal at a discount. Some months ago, I had written that the discount on Russian oil was obstructed from reaching us, but oil refineries seem to have successfully fought the trader monopoly. Russian steel is coming in at a discount of roughly 5% per tonne. The recent commendable policy announcement by the Reserve Bank of India (RBI), offering more attractive options to settle trade payments in rupees, is a huge facilitator. These discounted imports are, however, not large enough quantitatively so far to have a significant impact on headline inflation. The larger trajectory of global prices still matters critically.

The ban on private exports of wheat has insulated India somewhat from the global prices of cereals. An agreement mediated by Turkey and the United Nations, formalized on 27 June, permits Ukrainian grain exports from ports on the Black Sea, holding the promise of a fall in global prices. The agreement will also facilitate the export of fertilizer from Russia (the world’s biggest exporter), which will reduce a major cost-push factor driving up the cost of food.

But the downward movement in global prices of food and fertilizer will not be smooth or monotonic. The first ship loaded with grain successfully set sail from Odessa on 2 August, but the process could stall for a yet unforeseen reason.

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In the midst of all this confusion, what matters is inflationary expectations in India. For that, I find core inflation a better indicator than surveys, because expectations get reflected in price movements in health and personal services and in wholesale and retail margins. This is core inflation as I measure it, after removing fuel oil used for transportation from the widely used (but wrong) definition of core. Some analysts call my definition ‘core-core’, but I will stay with ‘core’ to assert that it is the true core.

When headline inflation was rising from October 2021, core inflation remained within its previous range of 5% to 5.5%. But it rose sharply and concurrently with headline inflation in April 2022 to peak at 6.5%, dropping back again to 5.5% in May. The worry is that even as headline inflation stabilized at 7% in June, core inflation rose from 5.5% to 6%. That is my indicator that inflationary expectations are rising, and when that happens, inflation feeds upon itself. July inflation will only be known a week from now.

What can monetary tightening conceivably do to correct expectations driven by external forces like the price of fuel oil, and within India by exogenous factors like the weather in key food crop areas? In more formal economies, it signals a commitment to inflation control, and through that, lowers expectations. In India, expectations are formed not by monetary policy rates, but by the experience of a non-volatile price trajectory.

Why raise policy rates in that case? The reason is that in a globalized world, where the US Federal Reserve has already raised the policy rate twice by 0.75 percentage points each time, and is predicted to raise it further in 2022 by anywhere from 1 to 2 percentage points, the repo rate in India cannot stand still. If it does, outward capital flows will lower the external value of the rupee, and the Reserve Bank of India cannot endlessly prevent a persistent downward movement. A tanking rupee means a rise in the price of imports (read fuel oil), and with that a rise in headline inflation. A rate increase is, therefore, needed at this juncture.

Indira Rajaraman is an economist.

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