In its last meeting, the RBI’s Monetary Policy Committee voted unanimously to keep interest rates unchanged and maintain a neutral stance. While the accompanying statements did lay out the rationale for the committee’s decision, several issues, beginning with inflation, need to be clarified.
Directionally, inflation is expected to trend upwards through the year. The central bank’s own forecasts have pegged inflation at 5.65 per cent in the second half of the year, up from 4.65 per cent in the first half. There is also the possibility of prices surprising on the upside, considering the situation in West Asia and uncertainty over the monsoon season.
The MPC, however, voted to keep the repo rate at 5.25 per cent. This implies that, on a forward-looking basis, real interest rates are mildly negative. As negative rates are meant to stimulate economic activity, this would suggest that policy is accommodative. This sits uneasily with the neutral stance the committee currently maintains. A neutral stance, as the RBI governor had earlier noted, calls for neither stimulating economic activity nor controlling inflation. So, is the MPC implicitly pursuing an accommodative policy while formally maintaining a neutral stance?
Currently, headline inflation is being driven more by food and fuel prices. While there is considerable uncertainty over energy prices, rainfall this season and the impact of El Niño going ahead, the RBI may well believe that price pressures will moderate towards the end of the year. It may thus view negative real interest rates as transitory, justifying its approach. But as forecasts beyond the second half of this year haven’t been released, it is difficult to know for sure. Price pressures may not dissipate. High WPI also does suggest inflation in the pipeline — inflation in manufactured products was 7.18 per cent in the first quarter. The extent of the pass-through of higher input prices depends on the pricing power of firms and domestic demand. Will growing market concentration tilt the balance? And what about the knock-on effects on inflation expectations and wages?
Then there is the issue of how the central bank views the underlying economic growth momentum.
In its commentary at least, the RBI continues to be optimistic about the country’s growth prospects. Like last year, it continues to underline the “resilience” of the economy, even though it expects growth to slow down from 7.7 per cent in 2025-26 to 6.6 per cent in 2026-27. Behind this rhetoric lie uncomfortable questions.
The RBI believes that private consumption has displayed “resilience”. However, this is at odds with subdued core inflation, which points towards weak demand. “Sustained low level of core inflation indicates that there are no immediate broad-based demand pressures in the economy,” an MPC member had noted in the most recent meeting.
The central bank has also argued that fixed investment has maintained its momentum. Yet, its most recent financial stability report has also noted that “private corporate investment remains subdued as reflected in the moderation in the investment to GDP ratio”. So, is it the RBI’s view that investment activity is still driven by public capex? Do both private consumption and investment need continued support? With inflation edging upwards and growth slowing down, what is the central bank more worried about — growth or inflation?
The calculus, however, does not end there. There is the issue of the rupee and the US Fed.
There have been times when the RBI’s interest rate decisions appear to have been guided not by inflation considerations, but more by the desire to defend the rupee. The pressure on the currency, which had eased, now appears to be reigniting following the renewed conflict in West Asia. Will the RBI raise rates if it believes that the measures announced so far are unlikely to ease the pressure on the currency? And what happens if the US Fed also raises interest rates? While inflation in the US has come in below expectations in June, there is a possibility of the Fed raising rates over the next few meetings. If that is indeed the case, will US monetary policy, as it has seemed in the past, influence the RBI’s interest rate decisions?
The central bank should clearly spell out its views on these issues.
Till next time,
Ishan Bakshi
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