Why the RBI may need to move in October

A rate increase would restore some real monetary restraint as inflation expectations rise and growth remains strong

When the Monetary Policy Committee (MPC) meets in October, it will confront an awkward choice. Inflation has not yet become as broad-based as it was in 2022, when food and energy shocks spilled into other prices, core inflation rose above 6 per cent, and the Reserve Bank of India (RBI) subsequently embarked on a sharp tightening cycle, raising the repo rate by 250 basis points. Nor is the current increase innocuous. Consumer inflation has climbed for three successive months to 4.82 per cent in August, the RBI expects it to reach 5.9 per cent in the December quarter, and gross domestic product growth has surprised on the upside.

 

The balance of risks favours a 25-basis point repo rate increase. The case rests less on the August consumer price index (CPI) print than on whether repeated food and energy shocks are feeding into broader price-setting.

 

Much of the inflation India is experiencing still originates on the supply side. Food inflation was 5.95 per cent in August, while fuel and power prices at the wholesale level were almost 23 per cent higher than a year earlier. If these pressures remain confined to food and energy, the case for monetary tightening would be weak, as more expensive credit would restrain demand without doing much to increase supply or address the source of the price increase.

 

The flexibility built into India’s inflation-targeting framework since 2016 allows the RBI to look through temporary supply shocks, but not persistent spillovers. An RBI study published in August 2024 (“Are Food Prices Spilling Over?” by Michael Debabrata Patra, Joice John and Asish Thomas George), makes the point using the central bank’s Quarterly Projection Model. It finds that a one-off food-price shock has little lasting effect on core inflation, whereas repeated shocks can raise inflation expectations and core prices, especially when aggregate demand is firm. And that is the risk the MPC now must assess.

 

The first indication of broader price pressure comes from core inflation, which rose to about 4.2 per cent in August. The sharp rise in precious-metal prices, however, makes that measure a noisy guide to underlying inflation. More informative is the movement in individual non-food categories, where price increases have become somewhat more widespread.

 

A closer look at the composition shows where some of the pass-through may be occurring. Inflation in food-and-beverage serving services rose to 8.41 per cent in August from 7.75 per cent in July. More significantly, inflation in transport services for goods almost doubled, from 7.77 per cent to 14.64 per cent. At a broader level, inflation in restaurants and accommodation rose from 6.91 per cent in June to 7.72 per cent in July, and 8.38 per cent in August; transport inflation also rose over the same period, from 4.31 per cent to 4.43 per cent and then to 4.60 per cent. Though it is too early to call inflation broad-based, rising freight and restaurant prices could transmit higher food and energy costs through the consumption basket.

 

The recent growth data have also changed the cost-benefit calculation for the MPC. Real gross domestic product grew 7.8 per cent in the June quarter, with private consumption rising 7.1 per cent and fixed investment 11.9 per cent. These numbers suggest that domestic economic activity is strong enough for firms to defend margins by raising prices rather than cutting output, and for the economy to absorb a small increase in borrowing costs. A quarter-point rate increase is easier to justify when growth is close to 8 per cent and inflation risks are rising.

 

Significantly, the real policy rate has fallen even though the repo rate has remained unchanged. At 5.25 per cent, the repo rate may appear reasonably firm relative to current inflation levels. But monetary policy is forward-looking. The RBI itself expects inflation at 5.9 per cent in the December quarter, 5.5 per cent in January-March, and 5.3 per cent in the following quarter. Against that path, the real repo rate is close to zero and turns negative over part of the horizon. An earlier RBI study estimated India’s natural real rate at 1.4-1.9 per cent, while cautioning that such estimates carry wide uncertainty. Even allowing for that, the monetary policy stance does not look particularly tight on a forward basis.

 

The latest liquidity position has made monetary conditions even more accommodative. The banking system moved into a surplus of more than ₹10 trillion after large foreign-currency inflows, including about $127 billion in deposits under the RBI’s special mobilisation arrangements. The result was visible in the money market — overnight rates slipped below the policy corridor, even though the repo rate itself was unchanged. The RBI has since announced ₹1 trillion of bond sales and used foreign-exchange swaps to drain liquidity. In India’s operating framework, the weighted average call rate is the variable through which the policy stance is transmitted to the overnight market. If this rate remains below the level intended by the MPC, the effective monetary stance is easier than what the repo rate alone would suggest.

 

A 25-basis-point increase would restore some real monetary restraint when expected inflation has risen, liquidity remains easy and growth is strong. It need not signal the start of a tightening cycle. Subsequent moves can depend on whether the rise in services and other non-food prices persists. The argument for acting now is simply that monetary policy is more effective when it responds before persistence is fully established, rather than after expectations and price-setting have adjusted and become costly to reverse.

The writer is associate professor, economics & public policy, Indian Institute of Management Ranchi.

 

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