Adequate response: on the RBI and inflation

The Reserve Bank of India (RBI) has finally taken action to combat rising inflation, raising interest rates by 25 basis points (bps) in its latest Monetary Policy Committee (MPC) meeting. This decision was long anticipated, with the RBI projecting retail inflation at 4.9% for Q2, up from its August forecast of 4.7%. The inflationary pressure is set to intensify in Q3, reaching 6%, before easing marginally to 5.7% in Q4.

The surge in global oil prices has been a significant driver of India's inflation woes. Oil marketing companies have largely avoided passing these increased costs onto consumers, but the situation is expected to change soon. Higher petrol and diesel prices are expected to contribute to a further rise in inflation, which could spiral out of control.

Simultaneously, a deficient monsoon has exacerbated food price inflation, adding to the overall inflationary pressure. Supply-side factors are primarily responsible for the current inflation trend, meaning that interest rate hikes have limited efficacy in addressing the issue. In such circumstances, the RBI's signal becomes crucial, as it can help temper inflation expectations and prevent them from turning into a self-fulfilling prophecy.

The MPC's decision to change its stance from 'neutral' to 'calibrated tightening' is a significant step in this regard. The signal now sent by the MPC is that the central bank will employ all available tools to contain inflation effectively. While the question now shifts from whether the RBI will hike rates in its next meeting to how much the hike will be, the central bank believes that the economy can withstand such tightening.

Furthermore, the RBI has revised its GDP growth forecast for 2026-27 upwards to 7.1% from the 6.7% projected in August, indicating confidence in the economy's resilience. The expectation of higher interest rates may also provide some respite from the ongoing exodus of Foreign Portfolio Investors (FPIs), giving the RBI some leeway in controlling the exchange rate.