RBI has no option but to raise rates

These decisions are being forced upon us while development is faltering both globally and in India. The International Monetary Fund’s April 26 update to the World Economic Outlook lowered growth forecasts for most countries, including India. Indian growth is projected at 7.4% (for the current fiscal year – a recent exception for India from the IMF’s customary calendar years). The consensus among domestic analysts is even lower, at 7%.

Headline Indian inflation has trended upward after October 2021, long before the Russo-Ukraine war, due to difficulties in preparing the supply side post-pandemic. But it was the war-induced rise in the price of fuel oil that caused the shocking spike in March 2022, rising 7.8% year-on-year in April. Brent crude prices have remained volatile since then, but have moderated since June. Domestically, a round of fuel tax cuts in May 2022 helped. There may be some easing of global supply-side constraints on fuel oil and gas, although there has been no recent promise to stop Russian gas supplies to Europe. Energy sourcing could become more widespread with the possible reactivation of nuclear plants in Germany. Global prices of non-fuel goods have fallen from their April peak, although fertilizers (we are one of the world’s leading importers) have declined only 12%.

In India, we are finally getting Russian oil and coal at a discount. A few months ago, I wrote that discounts on Russian oil were a barrier to reaching us, but oil refineries have successfully fought off merchant monopolies. Russian steel is coming in at a discount of about 5% per tonne. The recent commendable policy announcement by the Reserve Bank of India (RBI) offers a more attractive option to settle trade payments in rupees, which is a great convenience. However, these concessional imports are not yet quantitatively large enough to have a significant impact on headline inflation. The larger trajectory of global prices still matters critically.

Restrictions on private exports of wheat have isolated India to some extent from global prices of the grain. An agreement formally mediated by Turkey and the United Nations on 27 June allows Ukrainian grain exports from ports on the Black Sea, promising a drop in global prices. The agreement will also facilitate the export of fertilizer from Russia (the world’s largest exporter), reducing a key cost-push factor driving up the cost of food.

But the fall in global food and fertilizer prices will not be smooth or monotonous. The first grain-laden ship successfully sailed from Odessa on 2 August, but the process may have stalled for an as yet unforeseen reason.

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Amidst all this confusion, what matters is the inflation expectations in India. For that, I find core inflation a better indicator than surveys, as expectations are reflected in price fluctuations in health and personal services, and in wholesale and retail margins. After removing fuel oil used for transportation from the widely used (but incorrect) definition of core, this is core inflation as I measure it. Some analysts call my definition ‘core-core’, but I’ll stick with ‘core’ to say it’s the real core.

When headline inflation was rising since October 2021, core inflation remained within its previous range of 5% to 5.5%. But it rose sharply and concurrently to 6.5% with headline inflation in April 2022, falling again to 5.5% in May. Worryingly, despite headline inflation stabilizing at 7% in June, core inflation rose to 6% from 5.5%. This is my indicator that inflation expectations are rising, and when it does, inflation feeds on itself. The July inflation will be known only a week from now.

What can monetary tightening do to correct expectations driven by external factors such as weather in key food crop sectors, fuel oil prices, and external forces within India? In more formal economies, it signals a commitment to inflation control, and thereby lowers expectations. In India, expectations are formed not by monetary policy rates, but by the experience of a non-volatile price trajectory.

Why raise policy rates in that case? This is because in a globalized world, where the US Federal Reserve has already raised the policy rate twice each time by 0.75 percentage points, and is predicted to raise it by anywhere from 1 to 2 percentage points in 2022. India cannot remain stable in repo rate. If this happens, external capital inflows will reduce the external value of the rupee, and the Reserve Bank of India may not be able to stop the continued downward movement. A tanking rupee means an increase in the price of imports (read fuel oil), and with it an increase in headline inflation. Hence, there is a need for rate hike at this juncture.

Indira Rajaraman is an economist.

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