ET View: Caution on poll-year inflation behind policy rate hike

Today’s has been the second consecutive rise in the repo rate by 0.25% by the monetary policy committee (MPC). Clearly, the committee has opted for caution in the face of hardening inflation prospects, over rushing to push up growth, expected to be a decent 7.4% for the current fiscal. However, the policy says that the RBI’s stance remains neutral.

A remarkable feature of the statement issued by the committee is the total silence on the subject of the exchange rate and the possible effect it could have on inflation. But there is no way this could not have had a role in determining the direction of rate change.

While the RBI does have ample reserves with which to intervene in the currency market, such interventions are reserved for dampening volatility, while leaving supply and demand to determine the exchange rate level. Capital flows have been strong in terms of direct investment, but tame and mostly outward in terms of portfolio flows. Higher oil and commodity prices tend to widen the current account deficit and this, too, would put pressure on the rupee.

A weaker rupee would make all imports more expensive. India imports 80% of its crude oil and when its price goes up, thanks to a lower rupee, it would have an impact on prices down the line. As it is, non-food, non-fuel components of the price index have hardened, and any decline in the rupee, with its impact on import prices, particularly that of oil and coal, would have cascading effects on domestic inflation.

Higher minimum support prices and election-eve fiscal profligacy could further fuel inflation. A higher rate of interest could, at the margin, make India slightly more attractive for foreign capital and ease some of the pressure from capital flight to safety from emerging markets amidst trade war and other geopolitical tensions.

The good news is that the MPC estimates the output gap — the difference between actual and potential growth rates — to have disappeared. This means that investment, which has been the weak spot in the economy for some time, will have to go up, to drive revenue and earnings growth.

A revival of investment is not held up by the cost of capital. So, on balance, controlling inflation and keeping the rupee steady would help growth, rather than keeping the cost of capital marginally lower than what it takes to keep a lid on inflation. If the weighted average call rate goes up sharply in the money market, expect the RBI to pump in liquidity.


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