To hike or not to hike

January rate hike's reasons were true in December, too

In December's mid-quarter review of monetary policy, the Reserve Bank of India (RBI) surprised many by pausing in its repo rate hiking cycle. The rationale for this decision was that, even though the inflation readings going into the review were worrisome, the prospects of softening were bright, given that vegetable prices were a significant driver. As it happened, inflation did soften, mainly because of vegetable prices as anticipated. This resulted in widespread expectations that the status quo would be maintained in Tuesday's third-quarter review. However, the RBI opted to surprise again, raising the repo rate by 25 basis points to eight per cent.

The stated rationale for the hike was fourfold. One, consumer price index (CPI) inflation, though less than the previous month, is still high. But this argument could have been used to justify a hike in December as well. Two, core CPI inflation (that is, excluding food and energy) is also still high - also applicable in December. Three, while the baseline projection for CPI inflation at the end of 2014-15 is eight per cent, consistent with the committee's time path, upside risks to this forecast are significant. And four, wholesale price index (WPI) inflation - in particular, its non-food manufacturing component - has risen, reflecting a persistence of demand pressures. This argument is somewhat surprising on two counts. One, it is difficult to reconcile demand pressures with the current pattern of gross domestic product and industrial production growth. Two, as per the recommendations of the Urjit Patel committee relating to a new monetary framework, which were announced last week, the WPI should not matter. The CPI-versus-WPI debate is a well-worn one, but the RBI has now explicitly come down on the side of the CPI. If indeed demand pressures are present in the system, they should now presumably be detected from the CPI. This is, in fact, reflected in the rigidity of core CPI inflation, which the RBI believes is due to wage pressure on the prices of services and, through this, on the overall price level.

In short, going by the CPI, both headline and core, and its projected trajectory over the coming year, increasing the repo rate in December was the right thing to do, but wasn't done, while increasing it on Tuesday was also the right thing to do, and was done. Looking ahead, though, the RBI's guidance opens up the possibility that the rate hike cycle has ended. If the baseline scenario for CPI inflation pans out, the RBI sees no need for further hikes. This may come as a relief to some stakeholders, but the guidance is far more conditional than it may appear to be; forecasting the CPI is no easy task and the policy statement explicitly warns of significant upside risks. Further rate hikes should not come as a surprise, notwithstanding the apparently reassuring guidance.

This review also did away with the quarter and mid-quarter scheduling of policy reviews and shifted to an alternate month structure. Consequently, each of the six reviews will have two monthly data releases to work with, thereby reducing the vulnerability of the decision to an aberrant data reading.