Wait and watch: Geopolitical threats to inflation outcomes have increased

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) is meeting this week with three new external members. It is a tribute to the institutional strength that has already been created in less than a decade that change is happening in an orderly manner. The Union government has continued its commitment to appointing independent members to the MPC who have a breadth of experience in academia or financial economics and are outside the governing establishment. The three new members include the head of a major think tank, the director of a premier educational institution, and a well-known economist with rich experience in the financial sector. There is every expectation that the MPC will continue to function with the high level of reliability, independence, and transparency that it has set so far.

The choices, however, facing the newly reconstituted MPC are difficult. There is evidence that the inflation rate in India is on a downward trend. In July this year, for example, the consumer price index-based inflation rate dipped below 4 per cent, which is the RBI’s formal target. Partly thanks to some statistical artefacts, it reached levels that it had not seen since before the pandemic. Coming closer to the present time, high-frequency indicators suggest underlying drivers of increasing prices, including food prices, may be easing in the harvest season. Nomura has predicted the food price inflation rate will average about 4.5 per cent in the months from now till March 2025, which is of course significantly lower than the over 8 per cent it has averaged so far this year. However, given the sustained upside surprises on food prices in the recent period, which affects household expectations significantly, it may be prudent to wait for the arrival of kharif output in mandis. The government, which has an eye firmly focused on private-sector investment and economic growth, would be happy if the MPC responded to these softer prices by cutting rates swiftly to support a growth revival. And, indeed, it may be the case that over the next few months, such cuts may be warranted.

However, at this precise moment, there are significant downside threats the MPC must keep an eye on. High on the list are geopolitical tensions, particularly in West Asia. The war in Gaza is escalating into a bigger conflict. Israel first drew Hezbollah and Lebanon into the war, and now Hezbollah’s Iranian sponsors have responded. If all parties to the conflict continue to be this irresponsible, then the economic ructions that would follow hostilities in the region must be factored in. Crises in West Asia and consequent volatility in prices of petrochemicals have historically led to inflation spikes and broader economic instability in India. This has been the case in both Gulf Wars, for example, as well as in the early 2010s alongside the Arab Spring and sanctions against Iran. The MPC must keep this in mind when considering the dangers attached to early monetary loosening. Preparing for a period of volatility and instability must be the paramount priority at this point. Given the situation, it would be prudent for the MPC to wait and watch. It would also give it time to see the headline inflation rate aligning durably to the 4 per cent target.