The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) did what was expected of it and raised the repo rate by 50 basis points to 4.9%. Repo rate is the interest rate at which RBI lends to banks. A basis point is one hundredth of a percentage. The increase is expected to increase interest rates in the overall economy thus reducing demand and helping to control inflation.
At the same time, the inflation forecast for FY23 has been revised down to 6.7% from the earlier forecast of 5.7% made in April. Inflation is expected to be 7.5% between April and June, 7.4% between July and September and 6.2% between October and December.
Inflation forecast of over 6% has been accepted by the RBI that inflation is here to stay, something it has been reluctant to accept in the last two years, Governor Shaktikanta Das has said, adding that inflation was transient on several occasions. . As things turned out, it was anything but fleeting.
However, the first step towards solving a problem is to acknowledge that it exists. By predicting inflation close to 7%, the RBI has finally done so. And that’s a good thing.
Also, as per its agreement with the government, RBI is required to maintain inflation as measured by consumer price index or retail inflation as it is more popularly referred to with a band of +- 2% at 4% .
If retail inflation remains above 6% for three consecutive quarters, the RBI is considered to have failed to meet the inflation target. With inflation forecast at over 6% for the first three quarters of this financial year, it seems the RBI is now acknowledging that it is likely to fail to meet the inflation target during this financial year. As stated in the Monetary Policy Statement: “Inflation is likely to remain above the upper tolerance level of 6 per cent during the first three quarters.” This is mainly due to the reluctance of the RBI to accept persistent inflation.
One ideology suggests that the RBI cannot do much to control inflation, as it is driven by rising food and fuel prices. this is true. But inflation is no longer limited to food and fuel items and has become a more common phenomenon. In April, core inflation, which did not include petrol, diesel and other fuels for food, fuel and light goods and vehicles, stood at 6.5%. Also, as stated in the monetary policy statement: “Continuity of inflation could lead to a second round of impact on headline CPI.” This means that the RBI should continue to hike the repo rate.
In fact, the importance of monetary policy in such a situation is best explained by former RBI governor Raghuram Rajan in his 2016 speech: “Although it is difficult for us to control food demand… We can control demand, and discretionary items in the consumption basket through more strict monetary policy. To prevent sustained food inflation from becoming generalized inflation through higher wage growth, we must reduce inflation in other goods. ” Therefore, the argument that RBI cannot do much to control the current inflation does not really hold.
Apart from raising the repo rate by the RBI, another factor driving interest rates is the fact that the excess liquidity in the financial system has been reduced. It has fallen from around Rs 7.1 trillion two months ago to around Rs 3.2 trillion currently.
And finally, the stock market and bond market were expecting this growth and they have barely reacted to it. At the time of writing this, the BSE Sensex was up 0.4% at 55,321 points. The 10-year bond yield was up nearly 5 basis points at 7.47% from yesterday’s close. Bond yield is the return that an investor can earn by buying a bond and holding on to it until maturity.