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Posted by: Deepa Vasudevan on Mon, Aug 6th, 2018

Explaining - RBI's Rate Hike

Last week the RBI increased its policy repo rate by 25 bps, the second consecutive rate hike this year. The decision was widely expected by market participants, even though RBI’s preferred inflation measure- CPI- was at 5% in June- bang in the middle of the permissible 4% to 6% inflation range. That is because monetary policy is not about current inflation as much as it is about with inflation expectations and future inflation.

The main upside risk to inflation came from rising core inflation. Core inflation refers to inflation minus food and fuel components. When core inflation is rising- as it has for the past one year- prices of non-food non-fuel manufacturing inputs increase, corporate margins become narrower, and manufacturers face pressure to increase selling prices.  Whether they can actually do so depends on the demand situation; when demand is strong consumers do not mind paying higher prices, but if demand is weak, corporates are reluctant to raise prices and risk losing sales. The latest RBI Industrial Outlook Survey shows that 46% of the surveyed companies expect the cost of raw materials to go up in 2018-19Q2. In other words, there are strong price pressures which may be passed on as higher consumer prices in the near term. For RBI, this would have been a critical reason for clamping down on inflation. 

Three other factors are likely to have influenced the policy action. First, the global trade/currency war poses a serious risk to emerging economies. The Indian Rupee has depreciated by over 7% in 2018, dragged down by a strengthening dollar, foreign capital outflows, and the prospect of slower export growth. Some market polls predict the rupee will touch 70 to a dollar or lower by end-2018! In recent weeks, central banks of other countries have tightened monetary policy (Indonesia, Malaysia, Australia, Brazil). Like them, RBI probably hopes that hiking rates will stem capital outflows and manage the rupee to some extent.

Second, investors are worried about political risk, in view of impending state elections in end-2018, and Lok Sabha elections in 2019. Historically, pre-election years have seen an uptick in inflation driven by populist spending. The fiscal position is already tighter after the announcement of higher MSPs and substantial farm loan waivers; and election relating spending is likely to increase the currency in circulation. A tighter monetary policy provides the right balance to the inflationary pressures emanating from politically motivated spending.

Finally, crude prices have come off the highs of last month, but since Iran looks set to face US sanctions (unless a last-minute diplomatic solution is found), the resulting supply cut could push up oil prices again.

With so much uncertainty on the inflation front, it was prudent to tighten rates and send a clear signal about RBI’s inflation targeting intentions. Since monetary policy operates with a lag of 2 or more quarters, the impact of last week’s actions will be seen only in 2019.  The current tightening, therefore, should manage inflation expectations too. 

 

Figure 1: Rising Inflation, Depreciating Rupee

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