Happy hike year: Why RBI will raise rates again

Less than 24 hours before the Reserve Bank of India’s governor, D Subbarao, is due to announce a widely-expected hike in interest rates of 25 basis points to clamp down on still-high inflation, the government went and did a couple of things that seem set to add further pressure on prices in the economy: it (through state-run oil marketing companies) raised petrol prices by three rupees a litre.

On top of that, it also hiked the basic salaries of government employees and pensioners by 7 percent. The pay hike will be applicable from July 1.

That’s not all. Today, a high-powered government committee will meet to decide on capping the number of liquefied petroleum gas (LPG) cylinders owned by a household in a year at four, and increasing the cost of refilling any LPG cylinder beyond the fourth to about Rs 750 per cylinder.

Without doubt, these actions will stoke inflationary pressures to some extent. More expensive fuel will add to commodity inflation, while the pay hike will stimulate overall demand.

The RBI, meanwhile, has been trying to lower such pressures over the past 18 months by raising interest rates 11 times. Yet the wholesale price index rose 9.78 percent in August from a year earlier, faster than July 9.22 percent increase.

Seriously, there’s a problem here: there seems to be little co-ordination between the government’s and the RBI’s actions. While no one denies that aligning local petroleum product prices with international levels, or reducing subsidies and letting consumers pay for what they use, are good policies, the issue is that such decisions will keep throwing a spanner in the RBI’s works not just today but also in the future in terms of controlling prices. Economic Affairs Secretary R Gopalan earlier said the rate increases have had only a limited impact on inflation, which is mostly driven by supply constraints in the economy. “While monetary tightening has been able to anchor inflationary expectations up to a point, it has had limited success in lowering inflation to acceptable levels,” Gopalan said.

Unfortunately, it’s the RBI alone that keeps getting pressured to fix the problem. Until now, most economists had expected the central bank to pause its rate-hiking cycle after today. Hardly anyone had factored in the petrol price hikes of the day before, especially because it was such a sudden decision. And there will be some effect, even if petrol prices are not a large constituent in the inflation index. More importantly, it could be the start of hikes in other products like diesel.

Which means that the pause in rates now seems challenging. Price levels in the economy had been expected to come down after October, but that might not necessarily happen, unless of course, we have a sharp fall in international oil prices.

One thing’s for sure: the RBI will no longer be able to ease up on hiking interest rates, especially if the government does nothing but add to the problem.

Watch video: RBI likely to hike interest rates today