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As consumer index-based September inflation data which were released on October 12 was low at 5.02%, albeit higher than the targeted rate of 4%, in hindsight the October 6, 2023 decision of the Monetary Policy Committee (MPC) of Reserve Bank of India (RBI) to maintain the policy rate of interest at 6.50% appeared then reasonable. However, a small 25 basis- point increase to make the repurchase rate at 6.75% would have been more appropriate. The reason was there were withdrawals of hot money by foreign investors reflecting signs of loss of confidence in price stability efforts on the part of RBI. Added to these signs, there were indications that the El Nino’s adverse impact on agricultural crops, especially vegetables, including onions and tomatoes was lingering. A sensible question was: Is RBI serious in its efforts towards anchoring inflationary expectations?

Thus, supply shocks due to adverse weather conditions and demand shocks during excessive spending on the eve of Dussehra and Diwali seasons, and rising household debt, do not augur well. Though a number of times it was indicated that the accommodative monetary policy stance would be changed, it was not matched by actions, as recorded by a private member in the minutes of the six-member MPC meeting of October 4-6, which was released on October 20.

RBI’s categorical observation

The RBI Governor Shaktikanta Das told the Press soon after the October MPC meeting, he would continue the same policy rate at 6.5%, the highest so far during the current episode of inflation, which began in February last year 2022. It may be recalled that was the time, when the Ukraine-Russia conflict began, drowning that European Union in a “pool of shocks of supply” of several kinds including energy and food grains, as the two warring nations were meeting the oil and gas as well as wheat requirements. The Governor announced that RBI would continue “its monetary policy to remain extra alert and ready to act”. He also made it clear once again that the decision marked the stage of departing from the stance of monetary accommodation.

Further, he indicated RBI is not aiming at being in the comfort zone of “4% to 6%”, artificially created by allowing a margin of 2% above the 4% upper limit. The margin of 2% was considered earlier on the grounds that the Indian economy is primarily dependent on  monsoons, which were not often dependable. Furthermore, the Governor reiterated  that  “RBI’s target is the upper limit of 4%., and not 6%. And the range is “ 2%-4%”. He also cautioned that “frequent and recurring incidences of large and overlapping supply side shocks bring with them the risks of generalisation of inflation impulses, destroying the credibility of monetary policy, giving rise to de-anchoring inflationary expectations”. 

It appears two private members of MPC, both academics, have largely influenced the Governor’s thoughts. The minutes of the MPC meeting show that both Professors Ashima Goyal and Jayanth Varma clearly ruled out any more cuts in policy rate. Professor Goyal wrote that though “the policy allows a rise but that will not be required unless there are second round effects from the repeated supply shocks.” Professor Varma was more critical. Referring to the same stance repeated over last few MPC meetings that although withdrawing monetary accommodation was on cards any time, the policy rate continued unchanged, which “do not enhance the credibility of the MPC. I would much prefer a stance in which words are consistent with the actions.”

Early MPC emergency meeting?

Things have changed since October 7. On that day, when the Middle East, which supplies one third of the world supply of petroleum, was rocked. Israel was attacked and the fierce battle ensued and peace does not prevail any more in the region. The crude price, which has been rising since the advanced countries decided to pause their monetary tightening as they wanted to avert any possible return to recession occurrence, has been looking up for a while.  Supply shocks arising from disruption in smooth flow of crude appear to be real again.

They will be more serious once the conflict spreads and it engulfs the region. The worst scenario, yet to happen but there is growing fear that there would be disruptions to the Strait of Hormuz. Table 1 on crude price and inflation give the latest details. This conflict is much more worrying than the more localized Ukraine- Russia conflict.

The emerging economy of India is under threat, as all other developing economies. Fear is the crude price may soon touch $100/barrel. An oil expert, Mahesh Sachdev (a former envoy to Algeria and Nigeria) notes in his recent column in Economic Times, besides the crude price, the associated costs including tanker freight charges and war insurance would also go up. The latest data reveal in 2022-23 India’s consumption of petroleum products crude grew up 10.2%. Specifically, there were 13. 4% growth regarding petrol, 12% in diesel and 47% in aviation turbine fuel. More disturbing developments show domestic production of petroleum products by India in 2022-23 fell by 1.7% and import dependence on crude for India’s refineries has gone up to 87%.  Annual crude import bill in 2021-2 was $158 billion, up by 31%, despite Russia’s discounted crude price. We always face a rhetorical question: what can RBI and higher interest do? Will an increase in interest rate boost vegetable production?

True, seasonal factors and El-Nino syndrome are beyond any one’s control; let alone RBI’s. But aggregate demand can be controlled. It is a painful decision. Anchoring inflation expectations do yield results, as past experience has shown. The US Federal Reserve (the Fed) has not lowered the interest, since September when it paused the rate change. In October the Fed announced another pause with rate at 5.50%. unchanged, which is the second consecutive time, despite a clear downtrend in inflation and a gradual cooling of the labor market. The Fed would be still resisting the calls to relax, despite considerable success in controlling inflation in the US, unlike in the UK and Eurozone. Will RBI call for an emergency meeting of MPC in November second week, after the October inflation data are on hand by November 13?