RBI’s wait and watch phase is over as inflation demands a rate hike

RBI held its policy rate steady at 5.25% in August, arguing correctly that it needed greater clarity before acting. That clarity has been provided by subsequent data. With retail inflation well above the 4% target and on a rising trajectory, and with commodity price shocks beginning to filter more broadly through the economy, it's time for an interest rate hike at next week's meeting of the monetary policy committee.

Food and fuel inflation remain the key underlying drivers. Food inflation has risen from about 2% y-o-y at the beginning of the year, to 6% in August. Fuel inflation has risen even more sharply over the same period, from a mere 0.2% to the current 5.2%. These are unsurprising developments in a country that has historically transported about half of its crude oil and 90% of its LPG imports through the Strait of Hormuz.

The standard prescription for monetary policy in the face of a commodity price shock is to look through it. After all, central banks cannot influence the weather, or dictate the supply of crude. But that prescription holds only so far as the shock is temporary and contained. Clearly, the hope that the shock would be short-lived has long evaporated. With Houthis now endangering passage through the alternative Strait of Bab al-Mandab, it would be more prudent to prepare for a lengthy disruption of oil markets. As for the shock being contained, evidence suggests, instead, that second-round effects are spreading to other sectors of the economy.


Consider manufactured product inflation, which accounts for almost two-thirds of WPI. This reached 8.4% in August, highest in the current series. Meanwhile, the gap between wholesale and retail inflation narrowed: the WPI-CPI spread stood at 5.95 percentage points in May, but had closed to 5.1 points by August, with the convergence driven by rising CPI rather than by falling WPI. And core inflation - which strips out the impact of food and energy prices from the retail index - rose from 3.9% in July to 4.2% in August. Taken together, these indicators bear the distinct signature of a gradual producer-to-consumer pass-through, one that may have further to run.

Compounding this is a shift in the external policy environment. US Federal Reserve, European Central Bank and Bank of Japan have all raised rates in the past weeks. The Bank of England held, but 3 of its 9 members voted to hike. The US 10-yr yield is now hovering just above 5% against India's 7%. A smaller spread, of course, makes Indian securities less attractive to foreign investors, putting pressure on the exchange rate. And rupee depreciation contributes mechanically to higher import prices (whatever the merits or demerits of targeting the exchange rate, which is a separate matter). Last quarter, the import deflator rose at the blistering pace of 32%.

Finally, the real economy is expanding robustly. Last quarter's broad-based 7.8% growth, combined with rising capacity utilisation, suggests that RBI doesn't face the kind of stagflationary dilemma faced by more sluggish economies. In both the EU and Japan, with GDP growth projected at under 1% and underlying productivity growth that has been anaemic for an extended period, central banks have been faced with difficult trade-offs between curbing inflation and further dampening economic activity. RBI has the luxury of a less cluttered runway.

Real interest rates in India are already low. The difference between the repo rate and the August CPI print stands at only 43 bps. RBI's own projections put Q3 inflation at 5.9%. If that were to materialise, the real rate would turn negative, loosening monetary conditions just as price pressures intensify. The time to act is now.