close_game
close_game

All quiet on the interest rate front

Aug 21, 2023 09:02 PM IST

Should RBI use blunt instruments such as interest rates, or take comfort from softening core inflation? For now, it should be the latter

The economy has battled volatile external conditions in the past few years, but the management of both growth and domestic inflation has been broadly on the ball, helping anchor India’s economic backdrop with enhanced macro stability. However, not everything can be controlled, as can be seen in the current retail price spike of tomatoes, a domestic staple. From a national average of 32/kg in June, prices rose to 140/kg in early August — ranging from 40/kg to 250/kg during that period. While the spike in prices has played out in the past six to seven weeks, they have now started to correct, albeit slowly, with new crops arriving in mandis and supermarkets.

Onion traders from Nashik have decided not to hold auctioning at Lasalgaon and other markets in the district on Monday. (HT PHOTO) PREMIUM
Onion traders from Nashik have decided not to hold auctioning at Lasalgaon and other markets in the district on Monday. (HT PHOTO)

Still, looking beyond tomatoes, the prices of cereals (especially rice), pulses, vegetables such as onions, spices, and electricity are also rising. Should this trend change the course of policymaking, especially monetary policy, which is mandated to target inflation? The Reserve Bank of India (RBI) has kept interest rates on hold since February, but recent elevated Consumer Price Index (CPI) inflation prints are now driving markets to price in a (remote) possibility of another rate hike. This, despite RBI signalling that it is somewhat willing to look beyond a transitory price shock, in its latest August meeting. Still, for any policymaker, including RBI, the dilemma around the current situation is this: Does it choose to react to a supply-led price shock with blunt instruments, such as interest rates, or take comfort from moderation in underlying core inflation? For now, we believe it should be the latter. A central bank’s response usually considers how long the price shock is expected to persist and whether it permeates to other commodities. From this perspective, July CPI inflation breaching the upper bound of RBI’s target band represents a rather narrow shock, given that it is driven by perishable food prices.

To be sure, there are risks. Extreme weather and uneven rainfall distribution this year are causing intermittent spikes in food prices; first were tomatoes, and now onions are on a slower but clear upward trend. Inflation in non-perishables (cereals, pulses, spices) is also due to inclement weather and reduced supplies, primarily, and is not cyclical such as vegetable prices; therefore, it is likely to be sticky. For instance, cereal inflation has been in double digits since September 2022.

Furthermore, the possible onset of an El Niño weather pattern and its impact on kharif harvesting and rabi sowing is still uncertain. We highlighted in an earlier column that El Niño could potentially increase food prices towards the end of 2023. Recurring food shocks, thus, pose the risk of raising household inflation expectations, which while currently in check, could become unanchored, as food items are regularly purchased and dominate household spending. Encouragingly, year-ahead inflation expectations continued to decline, suggesting that inflation expectations remain anchored, for now. However, in our view, it would be a mistake to extrapolate this phenomenon, when prices of key food items continue to trend higher.

However, there is one silver lining: Core inflation (excluding food and fuel) has moderated to a three-year low. The persistence of core inflation has also eased, which indicates that inflation across key discretionary goods and services is not rising as broadly as it did earlier. RBI also has repeatedly highlighted the need to break the persistence in core inflation in order to bring overall inflation closer to its target of 4%. Moderation in core inflation in the July print thus offers some comfort for the central bank and gives policy space to observe the impact of the fiscal actions being taken.

To contain the current bout of food inflation, fiscal policy has swung into action. Since July, the government has announced a series of measures designed to contain the rise in food prices, including releasing onions from its buffer stock, auctioning rice and wheat stocks, importing tomatoes, and banning exports of non-basmati rice. These steps provide significant space for monetary policy, which we think has little control over food price shocks, leaving little to do on the interest rate front. Instead, RBI now seems to focus on liquidity management to ensure faster transmission of earlier rate hikes, as was evident in its announcement that banks would have to maintain an incremental cash reserve ratio. In our view, this episode of high inflation validates the caution that RBI has shown in 2023. The world remains gripped in a period of slowing, but not collapsing growth; and falling, but not low inflation.

RBI was able to achieve macro stability despite raising policy rates by only 250 basis points (bps), cumulatively, compared with the 525 bps by the United States Federal Reserve. But given a plethora of global and supply-driven price shocks, and India’s growth moderating, but still high relative to other regions, the Indian economy is also likely to be in a “higher for longer” interest rate environment — if 6.50% turns out to be the high-water mark for rates in the current tightening cycle. What could end this cycle?

Perhaps a significant downside shock to global growth that triggers a collapse in commodity prices, although this does not appear to be the case for now. Until then, it’s likely to be all quiet on the interest rate front, inflation spikes notwithstanding.

Rahul Bajoria is managing director and head of EM Asia (ex-China) Economics, and Amruta Ghare is regional economist at Barclays. The views expressed are personal

Get Current Updates on...
See more

Continue reading with HT Premium Subscription

Daily E Paper I Premium Articles I Brunch E Magazine I Daily Infographics
freemium
SHARE THIS ARTICLE ON
SHARE
Story Saved
Live Score
Saved Articles
Following
My Reads
Sign out
New Delhi 0C
Saturday, November 09, 2024
Start 14 Days Free Trial Subscribe Now
Follow Us On
// // //