MPC may hike repo rate by 25 bps before a pause

MPC may hike repo rate by 25 bps before a pause

Subject: Economy

Section: MONETARY POLICY

Context: Against the global balancing act between hiking interest rates, withdrawing systemic liquidity and the series of recent bank failures, the Reserve Bank of India’s Monetary Policy Committee (MPC) is likely to raise the policy rate by another 25 bps in its first bi­monthly monetary policy for FY24, taking cognizance of the contagion impact on the Indian economy

Can policy rate hikes alone control inflation?

• Inflation numbers for the first two months of 2023 have once again crossed the 6 per cent barrier of the RBI. Food and core inflation remained stubbornly high in February, above 6 per cent.
• According to internal research conducted by RBI, inflation exceeding 6 per cent would have adverse effects on India’s growth.
• It would negatively impact the financial savings and investment climate. Thus, the RBI’s rate hikes are a no-brainer.
• As the monetary policy framework mandates, the primary job of the RBI is to keep inflation in check. Therefore, few would disagree with the RBI’s rate hikes.
• The dominant role of commodity prices in India’s retail inflation has reignited the discussion on whether it is necessary to focus on targeting headline inflation. But these transitory fluctuations in headline inflation caused mainly by food prices can also lead to a rise in non-food or core inflation due to higher inflation expectations. Economist James Walsh, in a 2011 IMF working paper, ‘Reconsidering the Role of Food Prices in Inflation’, points to evidence that a policy focus on core inflation can mis-specify inflation, leading to higher inflationary expectations, a downward bias to forecasts of inflation and lags in policy responses.
• In a study, ‘Explaining Inflation in India: The Role of Food Prices’, Prachi Mishra and Devesh Roy examined whether food inflation affects non-food inflation in India. They found a significant pass-through effect from food price inflation to non-food inflation
• Renowned economist Nicholas Kaldor argued that monetary policy is not an effective tool to control inflation that is caused by supply-side factors, particularly those arising from the agricultural sector. Since monetary policy typically deals with the demand side of the economy, it cannot address inflation stemming from the agricultural sector. In their 2022 paper, ‘What lowered inflation in India: monetary policy or commodity prices?’, economists Pulapre Balakrishnan and M Parameswaran argue for a new set of instruments to control inflation arising from commodity prices.

Impact of US FED policy:

• In its latest meeting, the US Federal Reserve increased the interest rate by 25 basis points to 5 per cent. This reduces the difference between interest rates in the US and India, which triggers a set of chain reactions, including capital outflow, rupee depreciation, depletion of forex reserve, and current account deficit. This will prompt a rate hike from the RBI so as to contain the interest rate differential between India and the US.
• After adopting the flexible inflation targeting (FIT) framework, India’s average inflation declined notably compared to previous periods. CPI inflation, which is targeted in the framework, and WPI inflation were low and stable. Stable international commodity prices and moderation of minimum support prices also played an important role in stable inflation figures up to 2019. Inflation targeting, therefore, does not offer a complete solution to the inflation problem of developing countries like India prone to high exposure to supply shocks.
• The April MPC would consider an interest rate hike by more than 25 bps as inflation has gone beyond the projected level this quarter. The central bank, to achieve its long-term goal of stable inflation and growth, would have to look at different instruments to reduce the impact of supply shock-induced inflation volatility.