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Containing inflation remains a challenge

In line with market expectations, the Monetary Policy Committee (MPC) on Wednesday raised the policy repo rate by 35 basis points to 6.25 per cent. The standing deposit facility and the marginal standing facility rates have been adjusted accordingly to 6 per cent and 6.5 per cent, respectively. The committee has cumulatively raised the policy rate by 225 basis points so far in the current year, taking it to the highest level since February 2019. Notably, however, the policy rate is still negative in real terms and is expected to turn positive only in the fourth quarter of the current fiscal year. The Reserve Bank of India (RBI) expects the inflation rate to moderate to 5.9 per cent in the last quarter of this fiscal year. The rate is projected to be at 5 per cent and 5.4 per cent, respectively, in the first and second quarters of the next fiscal year.

In terms of policy action, while the pace of rate increase has moderated, the central bank is still some distance away from the terminal rate in the current cycle for a variety of reasons. However, the extent and timing of rate hikes from here on would depend on the evolving economic conditions. Even assuming the current projections hold, the inflation rate at 5.4 per cent in the second quarter of 2023-24 would still be significantly above the target of 4 per cent. Further, if the inflation projection for the fourth quarter of the current fiscal year is missed even marginally, it would mean the rate will remain above the upper end of the tolerance band for five consecutive quarters. This can certainly affect expectations. The MPC, therefore, would need to bring inflation closer to the target and maintain the level for a reasonable length to firmly anchor expectations.

The committee in this context has done well to emphasise the persistence of core inflation near the upper end of the tolerance band. While headline inflation is likely to moderate because of lower commodity and food prices in the coming months, persistent higher core inflation would always remain a risk for the headline number. Besides, the central bank would need to monitor the policy actions of large central banks, particularly the US Federal Reserve. A section of the financial market expects the Fed to moderate the pace of its rate hikes, though the incoming economic data suggests it may not be a done deal yet. Nonetheless, the Fed is expected to continue to push up the policy rate and keep it at higher levels till the desired disinflation is achieved. Although the currency market pressures have abated a bit, higher interest rates in the US and overall tightening global financial conditions would demand vigilance because they could affect capital flows, currency movement, and inflation outcomes.

Thus, given the domestic and global inflation conditions, monetary tightening is likely to continue, though at a relatively moderate pace. Tightening monetary conditions, however, would affect growth outcomes. The RBI expects growth to moderate to 4.4 per cent in the ongoing quarter and further to 4.2 per cent in the fourth quarter. This would clearly be far lower than desired. Since the RBI is rightly focused on maintaining price stability, the onus will be on the government to support growth.