All options open: Repo rate increase signals RBI's intent

Taken in isolation, the unanimous decision of the Monetary Policy Committee (MPC) to increase the benchmark repo rate by 25 basis points 1 the first increase in more than four years — may not make a significant difference. But it is a welcome move even if just to signal the intent of the Reserve Bank of India (RBI) at a time when most observers expected the central bank to keep the repo rate unchanged and come up with a policy statement that was more hawkish in its tone than the one announced in April. On Wednesday, after three days of deliberations, the MPC surprised there too as it maintained a “neutral” stance. On the face of it, this may be confusing and indeed contradictory, but as Governor Urjit Patel stated, it means the RBI wants to keep all its options open. The key variable to watch out for is inflation and the central bank will do all that it takes to keep that within the targeted band. 

Since its last policy statement in April, the RBI noted that one of its central worries had come true: The Indian basket of crude oil prices saw a 12 per cent jump from $66 a barrel to $74 a barrel within no time. Crude oil was not the only commodity that rose and, together with upheaval in global financial markets, led to a firming up of input cost pressures. Domestically — and the RBI clearly outlined its concern on this point — the worrisome aspect was the compositional shift in the drivers of inflation. Consumer price index-based inflation, excluding food and fuel, rose sharply by 80 bps since March. Not surprisingly, the RBI’s household survey in May reported a sharp spike in inflation expectations, both over the three-month and one-year horizons. The policy statement flagged several other factors that could threaten to push up inflation. Hardening of wages and input costs and the impact of implementation of house rental allowance by various state governments are some key upside risks. All this has resulted in the RBI revising its inflation projections for the current financial year. For the second half of the year, which is closer to the next general elections, the projection has gone up from 4.4 per cent earlier to 4.7 per cent now.

Another way to read the RBI’s decision is the confidence it has on the robustness of economic recovery in the country. “The MPC notes that domestic economic activity has exhibited sustained revival in recent quarters and the output gap has almost closed. Investment activity, in particular, is recovering well…” stated the policy statement. That explains the aggression on inflation control. The main concern is the government’s decision on minimum support prices (MSPs). With farm unrest still sustaining despite bumper production, it is likely that the government may opt for considerably higher MSPs, which will push up inflation both directly, via food inflation, and indirectly, via fiscal slippage that may follow. The RBI’s “neutral” stance thus signals both a carrot and a stick for the government. If budgetary targets are missed and private sector investment recovery is crowded out, there will be consequences in the shape of further rate hikes.