Amid rising inflation, RBI cannot neglect growth

Given that the RBI targets a retail inflation rate of 4 per cent, many do not rule out a repo rate hike. However, the RBI’s choice may not be as straightforward as it seems

This week, the Reserve Bank of India’s Monetary Policy Committee will deliberate on fine-tuning its stance on the repo rate — the interest rate at which India’s central bank lends money to commercial banks. Typically, when prices threaten to rise at a rate faster than what the RBI finds prudent, the central bank raises the repo rate to contain inflation. On the face of it, India is facing such a phase, with the war in Iran and the blockade of the Strait of Hormuz keeping the prices of crude oil and other critical imports high. Not surprisingly, inflation has started rising quickly. Wholesale inflation has already crossed the 8 per cent mark, and it’s only a matter of time before its effects filter through as higher retail inflation for consumers. Retail inflation has already spiked to 3.5 per cent after the RBI had brought it down to 2 per cent in the last financial year. Moreover, a weak monsoon could affect the farm sector and raise food prices. Most economists outside the RBI and the government expect retail inflation to rise further to 5 per cent and stay at that level for the rest of the year. Given that the RBI targets a retail inflation rate of 4 per cent, many do not rule out a repo rate hike.

However, the RBI’s choice may not be as straightforward as it seems. For one, the current rise in prices stems from a lack of supply of crude oil and other products. In the short term, there is little that the RBI can do to boost crude oil supplies. Raising interest rates may dampen India’s growth momentum at a time when it needs a more conducive environment. A US-Iran peace agreement, resulting in a swift boost to oil supplies and a quick moderation in oil prices, cannot also be ruled out completely. Also, at 5 per cent, inflation would still be within the RBI’s comfort band of 2 to 6 per cent.

The more important issues to watch this week will be the RBI Governor’s commentary on the state of the economy. Two issues will be of particular interest. One, the rupee’s exchange rate. Does the RBI want to prioritise maintaining an adequate amount of forex reserves and let the rupee find its own level, or is it willing to draw down these reserves to ensure that the rupee doesn’t slide beyond a certain point? Two, what needs to be done for India to attract foreign capital. The RBI’s stance will be keenly watched.