Shifting expectations

The six-member Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) decided to leave the policy repo rate unchanged at its meeting earlier this month, which was a prudent decision. Although the inflation rate exceeded the target in June, it remained below target for 16 consecutive months. Furthermore, it made sense to wait for more clarity on both the international and domestic fronts. The situation in West Asia does not seem to be improving significantly, making prices of crude oil excessively volatile, which requires continued monitoring. By the next meeting, there will also be more clarity on the possible impact of a deficient monsoon on agricultural output. However, as this newspaper argued then, the RBI’s inflation projections suggested that the policy rate would not remain at the present level for too long. The minutes of the meeting, released on Wednesday, are being interpreted along similar lines.  

In the minutes, RBI Governor Sanjay Malhotra argued that there was a need to remain watchful of a broadbased increase in inflation and de-anchoring of expectations. He further noted: “Any evidence of these risks materialising may need policy tightening.” Deputy Governor Poonam Gupta was more direct and noted: “... scope for any further easing does not seem to exist at the current juncture. Instead, given that the headline inflation is projected to peak to a level as high as 5.9 per cent in Q3 2026-27, a case for a hike may emerge during the course of the year.” The RBI’s inflation projection for this financial year was reduced by 10 basis points to 5 per cent. However, the rate is expected to remain above 5 per cent for three consecutive quarters starting the third quarter of the financial year. It would be interesting to see the projections beyond the first quarter of 2027-28. More clarity will likely emerge at the next MPC meeting in October and with the release of the biannual Monetary Policy Report. 

Nevertheless, as things stand, price pressures are projected to increase. With the headline inflation rate going above 5 per cent and peaking at 5.9 per cent in the third quarter, the policy repo rate at 5.25 per cent would turn negative in real terms. This is undesirable. It is also not the objective of the RBI to keep the real policy rate in negative territory even in the short run, particularly when growth is not at risk. Thus, policy rates need to be adjusted. Conditions will become clearer in the coming weeks as to whether the MPC will begin tightening in October or have the room to wait for some more time. Inflation projections for next financial year will be crucial. It must be noted that monetary policy works with a lag, and if the inflation rate is expected to remain elevated next financial year, tightening may begin in October itself. 

Although monetary policy in India is not driven by developments in the currency market, policy adjustment to address inflation conditions may help it. Yields in developed markets are increasing due to concerns such as higher inflation rates and larger fiscal deficits. The United States (US) government, for instance, has decided to increase long-dated bond buybacks to bring down yields. The yield on the 30-year US government bond went above 5.3 per cent earlier this week, the highest level since 2007.  A narrow yield gap tends to discourage debt-capital flows from developed to emerging markets. However, India is now in a better position, at least in the near term, on the currency front. It is mobilising substantial funds through swap arrangements announced by the RBI. Nevertheless, adjustment in policy rates may help debt flows.