RBI faces tough call on interest rate, policy panel decision likely on Friday

The Reserve Bank of India’s (RBI) Monetary Policy Committee (MPC) started its meeting Wednesday and is expected to arrive at a resolution Friday. The existing monetary policy framework mandates the central bank to use interest rates as an instrument to keep inflation under the mandated range of four plus minus two percentage points. The choice in front of the MPC members is not going to be an easy one.

Movements on the external front are generating tailwinds for inflation. Oil prices are close to $85/barrel on Wednesday and the value of rupee touched 73 to the dollar for the first time. This spooked investors leading to a fall of 550 points in the Sensex. (See chart 1)

Analysts expect oil prices to breach the psychological barrier of $100/barrel in the near future. This is bound to generate more inflation in the days to come. What happens in the future is important because the RBI’s decision on whether or not to hike rates is driven more by expectations of future inflation rather than present levels.

A hike in interest rates at this point can also help the external balance situation as higher interest rates (which means better returns) might attract more foreign inflows. The first two quarters of the current fiscal year have seen a net outflow of $11.2 billion worth of foreign capital from debt and equity markets. (See chart 2)

A rate hike however is also likely to generate headwinds for domestic investment and consumption activity. According to the Centre for Monitoring Indian Economy’s capex database, new investment announcements have been falling in the last two quarters. A rate hike can accentuate this fall, resulting in a slowing of economic growth which the country can ill-afford. (See chart 3)