With the RBI credit policy round the corner, the focus is naturally on the decision on interest rates. The fact that inflation has touched the psychological mark of 5 per cent shows that it could move up further in the coming months. The views of the MPC members will be important.

The overemphasis on the CPI inflation number is interesting because it has become the fulcrum for policy making. But is this the right indicator? When the WPI was used, critics had argued that the CPI was more relevant as it affected our lives and use of WPI understated inflation. When the CPI became the anchor, critics were quick to point out that while it helps to determine real income, interest rate action through demand management cannot affect prices if the problem is on the cost side.

If CPI inflation is driven by higher prices of pulses, then increasing rates does not help the cause. If people demand less tur when prices reach ₹100 per kg, demand may come down as it becomes unaffordable to many. Yet, prices do not adjust until the next season. Therefore, there is no clear answer here. But the RBI has decided to target CPI inflation and 4 per cent being the so called ideal target with a band of 2 per cent on both sides.


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Why did the committee choose 4 per cent? Evidently there were models which threw up this number and so this has become a benchmark. The MPC came into being from the October 2016 policy when it took charge of the process. At that point of time, if the Committee had looked at the CPI inflation number of the last 10 years based on the CPI index for industrial workers (the so called old CPI number which is still collated today), it would have found the inflation number always being above 5 per cent. The range was 5.6 per cent to 12.4 per cent. Going by the new CPI index, the inflation rate was 4.9 per cent in 2015-16 and at 5.8 per cent, 9.4 per cent and 10.1 per cent respectively in the preceding three years. Therefore, to start off targeting inflation rate of 4 per cent was always going to be interesting.

MPC’s record

Against this background how have the MPC members reacted? There have been 11 policies so far and two rate cuts of 25 bps each and one rate hike in June 2018. Further within the Committee, there was near consensus in the first four policies after which there has been one outlier in all other policies till the June 2018 one when there was again unanimity. The inflation given in the table would be the latest inflation rate that was available to the MPC when the decision was taken (the second month preceding the month in which the policy was announced). Further, the first policy under the MPC was announced when inflation had come down from 6.07 per cent in July 2016 to 5 per cent in August 2017.

Is it possible to draw a pattern here? The first rate cut took place when inflation came down to 5 per cent. Subsequently the rate remained unchanged in the next four policies even as inflation came down to 3 per cent in April 2017 when the policy was announced in June 2017. The rate was cut again when inflation touched 1.5 per cent which was 3.5 percentage points lower than the previous instance of rate cut. When the inflation rate remained below 4 per cent subsequently only one member voted for a rate cut, while the others favoured a neutral stance. When the rate of inflation crossed 5 per cent and remained above 4 per cent for the next two policies, the majority maintained an unchanged stance before pitching for a unanimous rate hike after the third data point.

The question is how will the MPC view the last inflation point of 5 per cent? Logically this should stir a debate of a further increase in rates as this will be the fourth time that inflation has strayed above the 4 per cent mark. As the policy has to be forward looking, the future trajectory will be the focus of discussion. So will rates go up further?

Based on the previous assessments of the RBI most of its concerns have already started playing out. First oil prices are rising and coupled with a weaker rupee landed cost is increasing as seen in the transport and fuel component. Second, the government has aggressively increased MSPs which can have a price-fuelling impact albeit at a progressively lower rate than the increase in prices.

Third, the HRA component of the States will now kick in causing the index to move up further. The RBI in its study on State finances has highlighted this point. Fourth, a fiscal slippage looks more real going by the constant shortfalls in the Centre’s revenue which has prompted several auctions of cash management bills as well as recourse to ways and means advances. This being a pre-election year, the possibility of fiscal slippage is high.

Inflation worries

Therefore, the possibility of inflation moving up further to the 5.5-6 per cent range cannot be ruled out unless food prices crash due to a good harvest. While a good harvest cannot be ruled out (though the present indications could be varied), the higher MSPs may provide support to prices and ensure that inflation does not fall. Therefore, unless non-food inflation eases, overall CPI would remain elevated. Under these conditions further rate hikes may be taken as being more or less given.

The timing of these rate hikes and the voting pattern in the Committee would be a matter of conjecture. Even if rates are not increased, this time there could be two members voting in its favour.

The writer is Chief Economist, CARE Ratings