MPC Meeting: RBI stays focussed on cooling inflation

The RBI’s caution on inflation has stood it in good stead as inflation has rebounded.

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) stood pat on interest rates even as central banks of advanced countries continue with rate hikes. The introduction of incremental cash reserve ratio to mop up excess liquidity created by the return of Rs 2,000 currency notes, which was not anticipated, could temporarily harden short-term rates. The RBI policy stance, however, did not come as a surprise to the markets.

Understandably, the rate hikes in advanced countries have been more aggressive as they are facing a steeper inflation challenge compared with India. The US Federal Reserve, for instance, has raised rates by 525 basis points (bps) versus India’s 250 bps in the current hiking cycle. While the Fed’s latest hike may well be its last for the current cycle, the European Central Bank is expected to continue tightening policy because inflation in its remit has been stickier.

Overall, interest rates are likely to remain higher for longer in the West given the headline inflation remains above redline and core inflation sticky. In contrast, the pressure on monetary policy in Asia has abated due to softening inflation.

Inflation Rebounds

The RBI’s caution on inflation has stood it in good stead as inflation, which appeared to have peaked during the June policy announcement, has rebounded. Mint Road has been relentlessly communicating that the fight is far from over and the August policy review reiterates this stance.

In the face of strong economic growth in the first quarter, the RBI kept its forecast for India’s GDP growth unchanged at 6.5 percent. But the recent spike in food inflation has created an upside to the RBI’s July-September CPI forecast of 5.2 percent — a number it now sees rising to 6.2 percent. For the current fiscal, it expects the CPI inflation print to be 5.4 percent, or 30 bps higher than the June forecast.

Various indicators point to an overall strong growth momentum in the first quarter. Government investments have expanded at a fast pace and credit growth is quite healthy. The Purchasing Managers’ Index was in the robust expansion zone and averaged 58 and 61 for manufacturing and services, respectively, during the four months ending July. Merchandise exports continued to contract for five months in a row, but that has not slowed down overall economic activity.

Interestingly, high growth is not the main reason for rising pressure on inflation. Rather food inflation is the culprit. In contrast to the services part of core inflation, which remains under pressure due to strong demand for services, the goods retail inflation is seeing a continued drop. Goods inflation, with one-third weight in the Consumer Price Index (CPI), plummeted from 12 percent in June 2023 over the same month last year due to sharp correction in input costs. The non-food part of the Wholesale Price Index, which is a proxy for input costs, fell on year in June.

Companies have passed on some part of the cost reduction to the end consumer and used the other to cushion profit margins. This trend is likely to continue through the year as suggested by the Business Inflation Expectation Survey from IIM Ahmedabad — average year-ahead inflation expectations of the firms remained within 4 percent for two consecutive months.

Additionally, fuel inflation is in low single digits due to the high base effect as crude prices continue to trail last year’s levels. The continued rise in international crude prices does raise concerns on this front. The services component of core inflation, which has a 27 percent weight in CPI, did come down but has been sticky in the last few months.

Pressure From Food Prices

Food inflation, with 40 percent weight, is the idiosyncratic part of inflation. Inflation in cereals, pulses and spices is in double digits and vegetable prices have risen sharply due to shock from weather and pests. Vegetable inflation, where spikes are normally transitory and correct in around two months, is not a lasting worry. But foodgrain inflation could prove to be tricky due to domestic and global factors.

Our research shows that food inflation can be high even when the monsoon is normal. For instance, food inflation printed over 6 percent in three of the past four normal monsoon years. The risk to food inflation from excess rains is playing out in vegetables and delayed sowing. The possibility of a weak El Niño, associated with dry conditions in the latter part of the monsoon season, was confirmed by Indian Meteorological Department recently.

From a global perspective, El Niño is also a risk to crops in other major global producing economies, such as palm oil in Indonesia and Malaysia and rice in Thailand and Vietnam. Among these, palm oil is a major import for India. Currently, edible oil prices are lower than last year, but a global shock can reverse this. For the record, India imports 60 percent of its edible oil requirement. The concern about food inflation is evident in the pre-emptive steps the government is taking, such as banning some types of rice exports, imposing stocking limits on wheat, and market intervention at reduced prices.

In this milieu, we expect rate cuts early next year if current food inflation pressure proves to be transitory and headline inflation stays on the projected trajectory. Although the RBI’s rate hikes cannot directly impact supply-side-driven food inflation, it becomes a concern if it sustains, spills over to other components, and steers headline inflation away from its target. Mint Road will, therefore, keep its eyes peeled on food inflation.

Dharmakirti Joshi is Chief Economist, CRISIL. Views are personal, and do not represent the stand of this publication.