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Brace For Higher Interest Rates

Context

Inflation has now remained above the RBI’s upper tolerance limit of 6 per cent for four months in a row.

Relevance

GS-III: Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development and Employment.

Dimensions of the Article

  • Broad Based Inflation
  • Inflation Targeting by the RBI
  • Implications
  • Way Forward

Broad Based Inflation

  • The second-order impact of higher fuel prices is also visible as inflation in transport and communication surged to nearly 11 per cent, from 8 per cent in the previous month.
  • The latest data also indicates that inflation is becoming broad-based. 
  • With demand rebounding, the pass-through of higher input costs is also gaining momentum.
  • Considering that demand for goods recovered faster than services, goods producers passed on input costs to consumers.
  • But as services recover, there will be greater pass-through of prices to consumers in the coming months.
  • While there may be a slight moderation, inflation is expected to remain above the RBI’s threshold of 6 per cent in the coming months.
  • The Ukraine conflict continues to impact markets for food grains and vegetable oils.
  • Rising fertilizer prices are likely to push up farmers’ production costs, leading to high food prices.
  • While the government has extended price support through higher subsidies, if this will be enough to cool prices needs to be seen.

Inflation Targeting by the RBI

  • With sticky crude oil prices and continuing supply-side disruptions amplified by the Covid-induced lockdowns in China, the RBI has rightly reverted its focus on inflation targeting.
  • This is needed as central banks around the world are pursuing tight monetary policies to counter inflation.
  • The US Fed followed its 25 basis points hike by another 50 basis points rise in May.
  • These will be followed by hikes of similar magnitude in the coming months.
  • In its April policy, the RBI announced the withdrawal of excess liquidity but did not raise the policy rate.
  • Rate hikes by RBI: The RBI is now likely to respond with aggressive rate hikes to prevent the price spiral from getting entrenched.
  • The continued strength of the dollar index and sharp rupee depreciation in the last few days could impose further pressure on prices through higher imported inflation.
  • Withdrawal of liquidity support: In addition to calibrated rate hikes, the RBI needs to fast-track the withdrawal of the ultra-accommodative liquidity support provided during the pandemic.

Implications

  • Discretionary spending: Rising inflation will cut back discretionary spending and adversely impact consumption that had only just started picking up.
  • Recession concerns: There are concerns about a recession in advanced economies as rising prices have started manifesting in a decline in purchasing power and a fall in consumer sentiments.
  • The demand destruction could trigger a moderation in prices.
  • Base metals prices have eased from the peak seen in the last few months.

Way Forward

Monetary policy support needs to be accompanied by fiscal support measures. The policy response will have to be tailored to the evolving geopolitical situation and the paths of commodity and food prices while balancing the imperatives of fiscal consolidation.

Source – The Indian Express

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December 2022
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