Testing tolerance

Price pressure will need a monetary response

The consumer price index-based inflation rate for March has surprised analysts. While economists were expecting the number to be higher than the upper end of the tolerance band, most didn’t expect it to surge to almost 7 per cent. The rate at 6.95 per cent (a 17-month high), its broad-based nature, and the sequential momentum suggest it is likely to remain elevated in the coming months. This means that the Monetary Policy Committee’s (MPC’s) projection of 5.7 per cent inflation rate for the fiscal year would come under pressure and warrant a different policy response. Although prices witnessed a broad-based increase, edible oil went up by over 18 per cent, while vegetable prices increased by more than 11 per cent. The core inflation rate also inched up to 6.3 per cent. The headline inflation rate has remained above the 6 per cent mark for three consecutive months.

The MPC in its review last week left the policy rate and stance unchanged. The Reserve Bank of India (RBI), however, moved forward with the normalisation process. It introduced the standing deposit facility and restored the breadth of the liquidity adjustment facility (LAF) corridor to the pre-pandemic level of 50 basis points. However, the inflation outcomes and revised projections from the private sector suggest that the policy is behind the curve. The RBI, for instance, should have restored the LAF corridor at least in the February policy meeting if not before. Similarly, the rate-setting committee should have shifted its stance to neutral because an accommodative stance doesn’t mean much now. As this newspaper has argued earlier, this would have given the rate-setting committee more flexibility to tailor its response in an uncertain economic environment.

The March inflation data has strengthened the view that the MPC would have to increase rates at a faster pace than what was expected until a few weeks ago. According to the RBI’s projections, the inflation rate would be at 6.3 and 5.8 per cent, respectively, in the first and the second quarter of the current fiscal year. It is thus likely on average the rate will remain above the tolerance band for three consecutive quarters, which, according to the law, will be treated as a failure to achieve the inflation target. The RBI would have to report to the government the reasons for failure, and propose remedial action and a time frame by when the inflation target would be achieved.

This would clearly put enormous pressure on the central bank and force it to raise policy rates. A new research note from Nomura, for instance, reasons that the inflation rate will remain above the tolerance band for the entire fiscal year. Both the government and private sector would have to adjust to this reality. Higher inflation and monetary policy response would push up market interest rates. The yield on 10-year government bonds went up by about 40 basis points in April. Higher interest rates, which are now unavoidable, could also affect economic recovery. The RBI, therefore, would need to reassess its inflation projections and reassure markets that the rate will be brought closer to the target in a reasonable time frame. A delay in policy response would affect expectations and increase the eventual cost of containing inflation.