Inevitable course-correction

Reserve Bank of India's (RBI's) decision to hike repo rate by 40 basis points and cash reserve ratio by 50 basis points has come as a surprise to market forces and policy analysts. With the hikes, the repo rate now stands at 4.4 per cent and CRR stands at 4.5 per cent. The increase in policy rates was an anticipated move but the manner and timing of the same carry an element of surprise. The RBI had clearly hinted in its April 8 MPC review meeting that it might take tightening measures to keep inflation under control but to do so in an unscheduled MPC meeting was beyond anyone's imagination. The key reason behind RBI's sudden move may be the realization that inflation in India at this time is not a passing problem — it is here to stay for longer. India's retail inflation breached RBI's upper limit in back-to-back quarters. The March inflation print nudged around 7 per cent and April print is expected to go further around 7.5 per cent. In global comparison, RBI's response to inflationary pressure has been quite delayed — it has decided to act only when the water level crosses over the nose. RBI's policy rate hike can also be seen in relation to the US' Fed policy rate modification — something that many economies are following and India too was feeling the heat to do so. Interestingly, the Central bank's formal policy stance still remains accommodative, meaning it will be focusing on growth on an overall basis. It remains to be seen what plans RBI has kept in the pipeline to balance between inflation and growth in these turbulent times. Notably, the RBI also acknowledged the problem of food inflation as a discomforting reality. A cursory glance on the reasons behind rising food inflation would show that the causal factors lie mostly on the supply side — be it high global prices, rise in fuel costs or disruptions in domestic food grain production. Demand side factors have relatively less role to play in rising inflation, as the economy is just opening up. Aggregate demand is estimated to be below-par and has, in fact, a depreciating impact on food inflation. Had the demand been more rigorous, the inflation scenario could have been worse. Additionally, the wage rates in large parts of India remain modest, keeping inflation under control. It would be pertinent here to consider how, and to what extent, the RBI's policy rate modifications will be able to control inflation. To put things in context, the RBI, over the past couple of months, has been making consistent efforts to pump out excess liquidity from the market by deploying methods like variable rate reverse repo (VRRR), standing deposit facility (SDF) and rupee-dollar swap among other things. The outcome on this front has however been very limited. It has to be seen how the 50 basis point rise in the CRR — aimed at absorbing Rs 87,000 crore of excess liquidity — pans out in the future. But what is for sure is that the abrupt manner in which the RBI is shifting gears can spell a disaster for recovering sectors like auto and real estate and also have adverse impact on the bond market. It is appreciable that the Central Bank has turned its eye towards managing inflation but the path has to be smooth and consistent. As the bank has hinted that it may further wean itself away from accommodative policy stance and focus rather on curbing inflationary pressures, the economy will likely witness further modifications in policy rates in coming MPC review meetings. The regulator must formulate an elaborate and transparent policy framework from hereon. In these turbulent times, it is very important that India's Central bank stands strong and firm on its high credibility. It must also try and avoid the embarrassment of rendering an explanatory note to the government for persistently breaching the threshold inflation limit! The government's role becomes extremely critical at this juncture. The Central bank can't be left alone to tackle the massive problem that is staring us in our face. RBI's move will bear positive outcome only if the government makes supplementary fiscal interventions. Both the entities must come together in cohesion before it is too late.