Policy response

Compelling reasons for an increase in the repo rate

The outcome of this week’s meeting of the six-member Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) will be closely followed. Aside from the decision on the policy rate, the meeting will also mark the completion of 10 years of the MPC. The first MPC meeting was held on October 3 and 4, 2016. A poll conducted by this newspaper last week showed that most economists expected the rate-setting panel to increase the policy repo rate by 25 basis points. There are compelling reasons for the central bank to adjust the policy rate. The consumer price index-based inflation rate increased to 4.8 per cent in August, as against 4.5 per cent in the previous month, and is expected to increase further.  The MPC’s own projections from the last meeting show that the rate is expected to increase to 5.9 per cent in the third quarter this financial year, and would remain above 5 per cent at least until the first quarter next financial year. 

It is possible that the inflation projection will be revised upwards. Renewed tensions in West Asia have again pushed up prices of crude oil. It is worth noting that pump prices in India have not been adjusted to fully reflect the higher global prices. Oil-marketing companies are running large under-recoveries, which may not be sustainable if oil prices remain at higher levels in the coming months. Besides, the monsoon has ended with a deficit of about 13 per cent. Although India has large foodgrain stocks, any impact on production, including on the output of perishables, could influence inflation outcomes. The food-inflation rate in August was close to 6 per cent. Furthermore, an inflation rate well above 5 per cent could push the real policy rate close to zero or even into negative territory, which is neither the objective of the monetary policy nor desirable in the present circumstances. Growth is not a concern for the MPC at this point. The Indian economy is growing at a strong pace and expanded by 7.8 per cent in the first quarter this financial year.  

Interestingly, the fact that most market participants expect the MPC to increase the repo rate, in a way, reflects how the flexible inflation-targeting framework, adopted a decade ago, has helped evolve market expectations. Since the inflation rate is expected to go well above the target of 4 per cent, the markets expect the MPC to act. Leaving the policy rate unchanged at this stage will require a great deal of explaining and could lead to an adverse market reaction. The framework and functioning of the MPC have substantially increased transparency in the conduct of monetary policy. The RBI has a clear target and objective, with the committee responsible for attaining that objective. The minutes of the meeting are released with the views of each member of the committee. In case the MPC is unable to achieve the objective, as defined in the law, it has to write to the government, explaining the reasons for failure and what it proposes to do to achieve the objective. 

A transparent policy framework and action in accordance with it help anchor inflation expectations, which is said to have considerable influence on actual inflation outcomes. A discussion paper issued by the RBI last year showed that the inflation rate had declined considerably since the adoption of the flexible inflation-targeting framework. With expectations getting firmly anchored, this will help the central bank maintain price stability over the medium to long term.