Moneycontrol Pro Panorama | RBI's MPC faces its moment of reckoning

Section 45ZN refers to what happens when the RBI fails to maintain the inflation target, which at present is set at 4 percent with a tolerance of 2 percentage points on either side. September’s CPI came in at 7.41 percent, meaning inflation was above the tolerance limit for three consecutive quarters. The section calls for a report to be sent to the government, which states reasons for failure, remedial actions proposed and a time period in which the inflation target can be achieved. Regulation 7 mentions that the MPC will meet to draft a report to be sent within one month of the inflation target not being met.

That’s the committee’s main mandate, for sure, on November 3. But the timing is interesting. The US Fed’s rate-setting committee is meeting a day earlier and it’s almost certain that it will increase rates by 75 basis points. The European Central Bank raised rates by 75 basis points yesterday. The last time the RBI held an off-cycle meet, also timed just after the Fed meet, it hiked interest rates. Will this time be similar or different? With the minutes of the last MPC meet showing that two non-RBI members had argued for a pause or at least a slowing of rate hikes, the odds are against any out of turn rate hike.

Nevertheless, the big question is: How high will interest rates go before it cuts into demand so much that inflation comes back to tolerable limits? Already, rural India is cutting back even on small essentials such as toothpaste and soap to make ends meet. The message from FMCG companies is very clear on that. The political cost of letting inflation be is risky enough for the government to insist on it being tamed rather than relax the inflation target to give the MPC more wiggle-room.

And that’s the thing. No one really knows how high interest rates need to go and then stay there till inflation comes under control. What the markets seem to be confident about is when concrete signs of a slowdown in demand emerge, then interest rates are likely to peak. But central banks will want to see the whites of inflation’s eyes before they scale back the assault. If they erred once on propping up growth post-pandemic with quantitative easing, then they may not lose sleep on the risk of doing too much to defeat inflation.

While Indian investors have taken many risks in their stride such as rate hikes in Western economies, Russia’s invasion of Ukraine, a slowdown in demand for Indian IT services, higher energy and input costs and the rural demand slump, the broader effects of a prolonged period of rising interest rates have not dawned yet. High interest rates work by subduing demand, and this can hit consumption in those areas that have so far not felt the pinch. If urban consumers start scaling back purchases, similar to their rural cousins, then it does not augur well for consumption growth. High interest rates could cool corporate capex plans as well, both due to higher funding costs and an uncertain demand outlook.

Whether the RBI only meets to discuss the report to be sent to the government, whether the government will make the contents of the report available to the public, and whether it also does an off-cycle rate hike, will be key factors investors should monitor. But some may also argue where's the accountability for failing to meet the target, if the MPC can simply get away by writing a report. What's the assurance this won't happen again and what are the consequences for failing to meet the target? Answers to these questions matter for the monetary policy's credibility. A pleasant surprise could emerge from external factors that help in cooling food or energy inflation. Today’s FT selection (free to read for Pro subscribers) points to how Europe’s energy crisis is nearing an end​, with no special forces at work but simply economics. Demand adjusted to higher prices and now prices are responding to lower demand. It’s beautiful to see textbook economics play out like this, of course, when viewed from a distance.

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Ravi Ananthanarayanan Moneycontrol Pro