Opinion With inflation at 8-year high, RBI has no option but to raise interest rates further

Surpassing consensus estimates by a significant margin, retail inflation, as measured by the consumer price index, rose to an eight-year high of 7.8 per cent in April as per data released by the National Statistical Office. This is now the fourth straight month that inflation has come in above the upper threshold of the central bank’s inflation targeting framework. The latest data only affirms the notion that inflationary pressures are far more broad-based and entrenched than what was previously believed. Moreover, these price trends also increase the possibility of inflation breaching the upper threshold of the inflation targeting framework for three consecutive quarters this year as well. This will only serve to reinforce the notion that the central bank has fallen behind the curve when it comes to managing inflation.

The surge in inflation was driven largely by higher food inflation. The consumer food price index rose to 8.38 per cent in April, up from 7.68 per cent the month before, with sharp rises observed in vegetables, cereals, and oils and fats. The data for early May suggests that food prices are likely to remain elevated, though there may be some moderation due to the base effect. However, food inflation is not the only source of concern. Core inflation (which excludes the more volatile food and fuel components) is now around 7 per cent. Most sub-groups, from clothing and footwear to household goods and services to personal care products, recreation and amusement are witnessing elevated inflation, which suggests that producers are passing on higher input costs to consumers. Equally worrying, core inflation is likely to remain elevated as pressure from the services segment builds up with demand for contact-based services rising.

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To tackle inflation, the monetary policy committee had held an off-cycle meeting in May, wherein the committee members had voted unanimously to raise the benchmark repo rate by 40 basis points. Alongside, the RBI also raised the cash reserve ratio by 50 basis points to drain liquidity. The off-cycle measures were an indication that the MPC had been underestimating the inflationary pressures in the economy. While the committee is yet to spell out its views on both the extent of policy tightening it is contemplating and over what duration as it looks to tame inflation, and prevent inflationary expectations from getting unanchored, elevated inflation readings will only increase the odds of the MPC aggressively frontloading the interest rate hikes. Considering that at the onset of the pandemic, the MPC had cut the repo rate in two instances by 75 basis points and 40 basis points, the move to raise the rate by 40 basis points now implies that another 75 basis points increase will be needed just to revert to the pre-pandemic level of 5.15 per cent. The terminal rate though is likely to be higher.

This editorial first appeared in the print edition on May 13, 2022 under the title ‘When prices pinch’.