Inflation risks

Supply-side issues will complicate policy choices

The six-member Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI), which is currently reviewing the policy and will announce its decision on Friday, is likely to have discovered that some of the drivers of inflation are changing. While prices of vegetables, particularly tomatoes, have come down, those of other food items are firming up. Meanwhile, crude oil prices have also witnessed a sharp increase  since the last policy meeting and are expected to remain elevated. Although the increase in crude oil prices may not push up the inflation rate immediately because oil-marketing companies have stopped adjusting to changes in international prices, there would nonetheless be some impact. The price of commercial cooking gas cylinders, for instance, was increased on Sunday. Although the consumer price index-based inflation rate eased a bit to 6.83 per cent in August, compared with a 15-month high of 7.44 per cent in July, it was still significantly above the upper end of the RBI’s tolerance band.

Most analysts expect the MPC to maintain the status quo on the policy repo rate. The 2.5 percentage point increase in the policy rate thus far in the current cycle is still working through the system and a considerable decline in the inflation rate looks unlikely in the near term. While the higher food price inflation hasn’t got generalised so far, the risk remains. The food price inflation rate in August was nearly in double digits and risks have increased owing to a deficient monsoon, which can not only affect kharif output but also the rabi crop because of the low availability of water in many parts of the country. Although the core inflation rate has moderated, the headline rate could make policy choices difficult.

Given the inflation outcomes and outlook, it would be interesting to see if the MPC revises its inflation projection of 5.4 per cent for this financial year. The World Bank, for instance, has revised its inflation forecast from 5.2 per cent to 5.9 per cent for this financial year, which is very close to the upper end of the RBI’s tolerance band and significantly above the target of 4 per cent. The MPC has thus far decided to sit out the spike in the headline rate, driven by food prices. However, a possible upward revision in the inflation projection would force the MPC to also take policy action in the coming meetings if not this week itself. Theoretically, it made sense to ignore price pressures emanating from vegetables, which usually reverse in a short period. However, given the supply-side risks, pressure from cereals and other items may be more enduring with a higher chance of getting generalised. Thus, the rest of the financial year could be fairly complicated for the rate-setting committee.

The international backdrop is not helpful, either. Bond yields in the US are rising in anticipation of at least one more rate increase by the Federal Reserve. Notably, the yield difference between 10-year Indian and US government bonds is at a 17-year low, which, along with the strengthening of the US dollar, will put pressure on capital flows. Since interest rates in the US are expected to remain higher for longer, there would be pressure on the rupee with implications for inflation outcomes. In the given situation, financial markets should not completely rule out the possibility of another rate hike.