Wait and watch

Food prices can increase policy risks

The six-member Monetary Policy Committee (MPC) of the Reserve Bank of India is reviewing the monetary policy this week amid the anticipation that the Consumer Price Index-based inflation rate went above the upper end of its tolerance band in July. The rate was 4.8 per cent in June. The surge in consumer prices is being driven by those of food, particularly vegetables. While vegetable prices are expected to come down as the seasonal factor subsides, the uneven distribution of rain and late sowing for the season in many parts of the country could put pressure on food production. The government is actively trying to contain food inflation. Although steps taken by the government, such as the imposition of restrictions on exports and stockholding limits, are not in the long-term interests of India’s food economy, they may contain prices in the immediate short run. Nevertheless, the near-term inflation outlook for India has worsened.

It is likely that the MPC will revise its inflation projection for the current financial year from 5.1 per cent. The extent of revision will be keenly followed by financial markets because it will directly influence the rate decision. Nevertheless, as things stand today, the MPC would be well advised to see through the spike in the headline rate, primarily driven by food prices. However, it would need to carefully observe the progress of the monsoon and the potential durability of food price inflation. If the monsoon is weaker than expected, with potential implications for inflation outcomes, the MPC will need to be ready to act. There is always a risk of food price inflation getting generalised. The central bank will need to contain this risk. However, given that core inflation has moderated and is expected to remain well below the headline rate, the MPC will have the comfort of postponing the rate action, if required.

Global uncertainties also warrant caution. Although inflation conditions have improved in advanced economies, the rate is still running above the target. The US Federal Reserve, for example, after a pause increased the policy interest rate by 25 basis points in July and is expected to tighten it further. The European Central Bank too increased the policy rate in July. The cumulative rate hikes in advanced economies and the resultant tightening in financial conditions will affect economic activity, with implications for global demand and commodity prices. However, the resilience in economic activities, particularly in the US, has surprised analysts. Some economists now expect the US to slip into only a mild recession later this year. Meanwhile, economic recovery in China seems to be faltering, which prompted the Chinese central bank to ease monetary policy. A slower than expected growth in China could exert downward pressure on global commodity prices.

Given that global economic growth is projected to remain below trend, excessive tightening could affect India’s prospects. Since the MPC has already raised the policy repo rate by 250 basis points in the current cycle, which is still working through the system, it makes sense to wait and observe at this stage. Communication from the central bank, however, will be critical. It would need to clearly underscore that the MPC remains committed to the 4 per cent inflation target and will not hesitate to act if there are hints of food inflation spilling over to other parts of the consumption basket.