While the monetary policy statement sounded neutral, the market had read the minutes of the August meeting as having a hawkish bent. The minutes had indicated some nervousness about the inflation dynamics and called for cautious monitoring of the inflation trajectory for signs of second-round effects. It seemed that the members were almost ready to hike but stopped short to allow for a better assessment of the inflation trajectory, as there were limited signs of inflation becoming broad-based back then. Further, there were no signs of the economy overheating.

The backdrop has, however, changed since the August policy.

Oil prices have hardened and broadly remained above $100 per barrel. With few signs of the West Asia crisis easing, there is little confidence that prices will fall. Deputy Governor Poonam Gupta had commented at the August MPC meeting that the oil price assumption was $90 per barrel for the remainder of the year. With oil prices now higher, there is a risk of this feeding through to retail inflation if the government decides to raise the prices of commercial LPG or petrol and diesel at the pump. Further, oil and its derivatives have a large impact on manufacturers’ input costs. Wholesale price inflation is already high, and there are expectations that these pressures will gradually be passed on to consumers. Auto manufacturers have already announced price increases, while others have signalled the possibility of similar moves soon.

Broadening Pressures

Signs of inflation becoming broad-based are also evident in the August reading. The momentum in food inflation has been strong in the three months leading up to August. Weak monsoon rains, low soil moisture and low reservoir levels are leading to fears of weak rabi sowing. Meanwhile, core inflation momentum also appears to have picked up. The consumer price index excluding food and beverages and fuel and light showed momentum of 0.55% in August compared with 0.26% in July, with momentum in the services segment also rising.

The broadening of price pressures is evident from the CPI diffusion index. As of the August data, 36.7% of items in the headline CPI show inflation of 4% or above, compared with 31% in June. June’s CPI reading was the latest available to the MPC when it met in August. On the core side, 20.8% of items show inflation of 4% or above, compared with 15.1% in June.

To complicate matters for all emerging-market central banks, including the RBI, the US Federal Reserve has started to hike policy rates. Even as the latest US employment and inflation data surprised on the dovish side, reducing the probability of another Fed hike in October, the US dollar index has continued to rise. This also implies that the rupee is on a depreciation trend, despite the RBI mobilising substantial inflows through the FCNR(B) window. Higher global yields have also narrowed the interest rate gap between India and the US, leading to foreign exchange outflows and consequent depreciation pressure on the rupee.

While the long-standing argument has been that the RBI does not follow the rest of the world in its interest rate decisions, this time around its room for manoeuvre may be limited, as it is also using funds raised at considerable cost through FCNR(B) deposits to intervene in the currency markets. The worry is also that the short forward book is now around $200 billion, and the room to intervene via the sell-buy swap route is also becoming limited.

Policy Response
The time is right for the RBI to raise the repo rate by 25 basis points in October. If it does not, the risk is that markets will start pricing in a 50-basis-point hike in December, and this could further steepen the domestic yield curve. Though it may not be articulated, the RBI may also hike as credit growth has been robust, exceeding its 10-year average and indicating a need to slow the economy.

Assuming the RBI starts in October, the cycle is likely to be a short one, with an increase of 50–75 basis points in the repo rate, as our internal model indicates that headline CPI inflation could fall back to the 4% handle by October–December 2027–28.

The only hitch is that liquidity continues to be in surplus even after rounds of variable rate reverse repo auctions, open market sales of government securities and sell-buy currency swaps. The concern, therefore, is that the impact of a rate hike may be lost as transmission may be weak, especially on the deposit side, as banks are saddled with substantial funds to deploy. Transmission will be faster on the lending side, with almost 66% of scheduled commercial banks’ outstanding loans now linked to external benchmark lending rates.

* Views expressed are personal.