Turbulence ahead rbi makes it clear inflation is now the big challenge governments need to gear up to fight it

Turbulence ahead rbi makes it clear inflation is now the big challenge governments need to gear up to fight it

The Reserve Bank of India’s monetary policy committee took the financial market by surprise yesterday. A little over three weeks after the six-member MPC voted unanimously to hold the policy repo rate at 4%, they changed course and increased it to 4.4% in an off-cycle meeting. It’s the first increase in repo rate since August 2018. RBI will separately increase the cash reserve ratio maintained by banks by half a percentage point to 4.5%. This is expected to suck out Rs 87,000 crore of liquidity. Monetary tightening is well underway now.

MPC was expected to nudge up interest rates later this year. The question therefore is, what triggered an unscheduled meeting to advance this? The answer is a combination of elevated inflation and the uncertainty around inflation’s trajectory. A volatile geopolitical situation has fuelled a surge in prices of many commodities. The pain has already shown up in India – retail inflation in March was 6.95%, led mainly by a jump in food prices. This surge in inflation has come at a time when even if aggregate demand is back at pre-pandemic levels, it’s not yet robust. The abrupt turn in monetary policy, therefore, was catalysed by a further apprehension.

The surge in fuel and food prices has come at a time when the price level of other items of consumption (core inflation) has remained high at around 6% for a year. MPC appears to fear the potential second-round impact of high commodity and food prices which occurs when firms raise sales prices and employees seek higher salaries to adjust to changing circumstances. Therefore, the primary aim of an increase in repo rate at this juncture is to head off the second-round effects and preserve macro-financial stability. As yesterday’s changes work their way through the economy’s full spectrum of interest rates, borrowing costs on personal and home loans will rise. For savers in fixed income instruments, rates are set to increase.

The key takeaway from the announcement is the return of inflation as an important macroeconomic challenge. This will force RBI to prioritise fighting inflation over stimulating economic growth. It does shift the onus onto both GoI and states to adjust fiscal policy to adapt to the emerging situation. For a start, taxes on pump prices of petrol and diesel need to be lowered to ease price pressure. Separately, agricultural policies need adjustments to ensure that food prices do not rise too high. The right fiscal policy will insulate the economy from a demand shock at this critical juncture.