MUMBAI: Owing to inflation pressures and a poorly performing rupee, the Reserve Bank of India (RBI) raised interest rates to its highest in two years. Amid growing concerns of economic instability due to trade wars between large economies and the rupee performing poorly this year,
RBI Governor Urjit Patel urged caution in announcing the rate hike saying in part, “The trade skirmishes evolved into tariff wars and now we are possibly at the beginning of currency wars”. The Monetary Policy Committee of the RBI voted 5-1 to raise policy rates by 25 basis points to 6.5%. In June, it raised the policy rates by 25 points as well.
The US Federal Reserve last week left its rates unchanged but would stick to a slow constricting policy in the coming months. With regards to the rupee, its Asia’s worst performing currency; down almost 7% against the dollar this year. A further complication is that it’s vulnerable to a slump with the Chinese Yuan amid its escalating tension on trade with the USA.
The economy as a whole is robust and growing at a fast rate. One challenge that could come up is the high fuel prices in the country. India is world’s fastest-growing oil consumer and higher crude prices will add to inflationary pressures. The rate hike by the RBI was its first back-to-back hike in almost five years. The Business Line editorial stated that the rate hikes could damage growth prospects – “Even as a combination of rupee depreciation and rising fuel prices has spurred headline inflation, there can be no denying that governments’ (Centre and States) unwillingness to reduce excise duties has exacerbated matters”.
The RBI did not rule out another rate hike in this financial year as Mr. Patel signaled that the apex body was sticking to 4% inflation target. There are risks to this target mainly due to two reasons – one, the volatility in crude oil prices and two, a significant increase in the minimum support price (MSP) for summer-sown crops. In its policy statement, the RBI said in part, “This increase in MSPs for kharif crops, which is much larger than the average increase seen in the past few years, will have a direct impact on food inflation”.
The result of the rate hike means banks will pass on this burden to borrowers; the State Bank of India has raised its long-term deposit rates. With regards to crops, the rainfall has been a little below the average and hasn’t covered as wide an area as last year. The Hindu editorial, calling the rate hike prudent, commented on the monsoon – “The monetary authority has flagged the need to keep a close watch on rain over the remainder of the season, given the risks regional imbalances may pose to paddy output and CPI inflation”.
The inflationary pressures are real. Retail inflation has gone up to 5%. The RBI sees price gains going to 5% in the April-June quarter of 2019. Outside factors have played a role in the MPC’s decision making process. There is a sense of trade protectionism creeping up, particularly the USA. This could impact investment coming into India, hurt supply chains and contribute to a decrease in productivity.
One good thing going for the Indian economy is that the macro strength is holding; the RBI in its policy statement said in part, “Various indicators suggest that economic activity has continued to be strong”. Some have argued that the RBI could’ve waited till October to assess the impact of the monsoon on crop and food prices before a consecutive rate hike.