In May 2022, the Reserve Bank of India’s monetary policy committee had held an unscheduled meeting. In it, the committee voted unanimously to raise interest rates by 40 basis points — this marked the beginning of the rate hike cycle in India. However, the unscheduled nature of the meeting and the policy action had raised several questions.
The May meeting was held less than a month after the MPC’s scheduled meeting in April. Even at the time of the April meeting, there were concerns over inflation pressures on the economy. Retail inflation had touched 6.07 per cent in February, with both food and core inflation inching upwards. Wholesale inflation had averaged 13.8 per cent in the preceding five months, and commodity prices were rising due to the Russia-Ukraine conflict. It was evident even then that the MPC had fallen behind the curve (‘Falling behind the curve’, IE, April 27, 2022). That it had failed to anticipate the price pressures on the economy and the possibility that inflation could exceed the upper threshold of the central bank’s inflation targeting framework for three consecutive quarters — fears that were subsequently realised.
So why did the MPC choose not to raise rates in April or act in its next meeting in June? Why did it raise rates in the off-cycle meeting in May when, in fact, it did not even provide an updated inflation forecast to justify the need for policy action? Did other considerations dominate the committee’s decision?
During this period, considering the surge in inflation, expectations that the US Federal Reserve was going to tighten rates, embarking on possibly the sharpest rate hike cycles in recent times, had gained traction. The Fed’s scheduled May meeting, when it hiked interest rates by 50 basis points — the first time in over two decades it had raised rates by this magnitude — also “happened” to be on the same day as the outcome of the unscheduled MPC meeting was announced.
This had then raised the question: Was the decision of the RBI/MPC to raise rates guided by the desire to maintain the interest rate differential, keep the exchange rate stable and prevent the rupee’s depreciation (‘Question of timing’, IE, May 9, 2022)? Or to put it differently: Was the objective of the policy action to curb inflation or defend the currency?
Now, fast forward two years.
Inflation in India has been trending low — the consumer price index stood at 4.83 per cent in April. Core inflation, which is a better measure of underlying price pressures in the economy, is at a multiyear low of 3.2 per cent, suggesting weakness in demand. What has kept headline inflation elevated is food inflation — the consumer food price index was at 8.7 per cent in April. Prices are elevated across several food groups. High food inflation presents a challenge for monetary policy. As a recent study by economists at the RBI also emphasised, “high food and fuel inflation can get generalised in the system through inflation expectations”.
Admittedly, there is uncertainty over the trajectory of food prices. While there are expectations of an above-normal monsoon, which will have a moderating influence on food prices, greater clarity will only emerge in the coming months. However, what matters for monetary policy is inflation down the line. And as per RBI’s own forecast, inflation is expected to average 4.5 per cent in the fourth quarter of 2024-25. So the question is: If India experiences an above-normal, evenly distributed monsoon, and there is greater confidence that food prices, and as a consequence headline inflation, will mirror the trajectory projected by the central bank, then will the MPC cut rates over the course of its next few meetings? Will the other committee members share external member Jayanth Varma’s view that a lower real rate — considering that the RBI expects inflation to average 4.5 per cent in 2024-25, a repo rate of 6.5 per cent implies a real rate of 2 per cent — can ensure that inflation aligns to the target? Or will other considerations dominate decision making?
At the beginning of this year, there were expectations that the US Fed would cut interest rates three times this year, with many pencilling in the first cut in June. However, recent inflation data and commentary from the Fed have led to the market reassessing the timing and the number of rate cuts. The minutes of the Fed’s meeting in May released a few days ago indicate a desire to hold rates higher for longer. Many are now expecting only one rate cut this year.
The situation, however, appears to be different across the Atlantic. Commentary from the European Central Bank and the Bank of England suggests that both are likely to cut rates this summer. Of course, both central banks would be well aware of the possible implications of such a policy action on their currencies. In fact, on the question of the Fed’s outsized influence on even the European Central Bank (ECB), Christine Lagarde, president of the bank, has pushed back, saying that the bank is data-dependent, not Fed-dependent. An independent monetary policy means that domestic interest rates are not influenced by international rates, they are determined independently. So while some may well believe that there are “practical limits on how far they (other central banks) can diverge from the Fed”, as a recent study by the economists at the RBI put it, the paths of both the ECB and the Bank of England as of now seem to be diverging as domestic growth and inflation dynamics are given greater weightage. Though to what extent remains an open question.
So what about the RBI? Will monetary policy be determined by the domestic environment, responding to the country’s growth-inflation dynamics, or the international policy cycle?
Borrowing from Lagarde: Will the RBI be Fed or food-dependent?
ishan.bakshi@expressindia.com
