In fight against inflation, MPC caught between a rock and a hard place

The RBI has retained the repo rate at 6.5 percent.

There were no surprises in the Reserve Bank of India’s policy announcement on August 10 except the higher-than-expected revision in the consumer price inflation forecast.

The central bank raised the inflation forecast for the current financial year to 5.4 percent from 5.1 percent while holding the key rates steady. The RBI expects inflation in the second quarter of FY24 at 6.2 percent, third quarter at 5.7 percent and 5.2 percent in the fourth quarter. The consumer price index (CPI) inflation for the first quarter of FY25 is projected at 5.2 percent.

Why the revision?

The price shock has come from a spike in the prices of vegetables, cereals and pulses in recent months due to seasonal factors. Food inflation surged to 4.49 percent in June from 2.96 percent in the previous month, pushing the headline retail inflation for the month to 4.81 percent from 4.31 percent in May. The CPI rose 2.5 percent month-on-month.

The core inflation, or non-food, non-oil part of the headline inflation, has remained in the range of 5.5 percent (in June) to 6.1 percent (in March) in the last four months.

Governor Shaktikanta Das’ singular focus now is to bring down the inflation to the 4 percent target though it is projected to rise.

“We have to stand in readiness to go beyond keeping Arjuna’s eye to deploying policy instruments, if necessary,” Das said, adding bringing headline inflation within the tolerance band was not enough. “We need to remain firmly focused on aligning inflation to the target of four percent,” he said.

But the monetary policy’s role is limited when inflation is fuelled by supply-side factors. In his policy statement, Das admitted as much and gave a subtle message to the government to act to address this problem.

“The role of continued and timely supply-side interventions assumes criticality in limiting the severity and duration of such shocks,” Das said.

The RBI wants the government to act further to ease the supply-side constraints. The Centre in recent days has announced some steps to cool food prices but may have to do more if the pressure persists.

The RBI since May 2022 has cumulatively hiked the rate by 250 basis points to control inflation, taking the repo rate to 6.5 percent. It has also acted on the liquidity front through reverse repo auctions. The 10 percent incremental cash reserve ratio announced from August 12 will further tighten liquidity in the system.

Beyond this, the RBI may not have more weapons in its arsenal to control a supply-driven price rise, which will have to be eased by the government.

A rate hike? 

A rate hike at this stage can hit the nascent recovery in growth and is unlikely to find support from the government in an election year. It means the MPC may have to stay on hold for a longer period and hope that the supply constraints don’t persist. It’s over to the government.