On the face of it, it may seem odd that RBI chose to hike policy rates by 25 bps after staying on hold at the December review. For, since then, headline CPI and WPI inflation have moderated 130 bps, food prices continue to correct, the anticipated industrial rebound at the end of 2013 did not materialise, and the government appears determined to stick to its budgeted fiscal deficit target, which will be a further drag on growth in the current quarter. Given all this, markets had begun entertaining the prospect of rate cuts later in the year. Another rate hike must seem like a bolt from the blue.
But dig a little deeper and one can fully appreciate why RBI acted. The guidance from its December pause was explicit. Headline and core inflation (with core CPI stuck at 8% for the previous six months) were too high for comfort. For RBI to stay on hold, both had to moderate. The first condition was met. Vegetable prices have corrected sharply in December and January—pulling down the headline rate with it. But core CPI inflation did not budge, remaining at 8% for a seventh successive month. From the perspective of a central bank’s credibility, there’s no point giving explicit guidance if it will not follow through on it. Had RBI not acted, markets would have accused the central bank of crying wolf and future guidance would have been discounted. To its credit, RBI acted decisively.
It is tempting to shoot the messenger—that the new CPI series is untested and has a short history. But a simple way to test whether it’s a simple measurement issue is to look instead at the CPI-Industrial Workers index—one with a much longer history and widespread acceptance. As it turns out, the picture does not change. Average core CPI between September 2012 and September 2013 (the last month for which data is available for CPI-Industrial Workers) is 8.3 % while that for the new CPI is 8.2%. So this is much more than a measurement issue.
Instead, the real macroeconomic puzzle is why is core CPI stuck at 8% when growth momentum continues to weaken. The only way to reconcile stubborn core inflation—in the face of weakening growth—is to come to the grudging acceptance that India’s potential rate of growth has, unfortunately, reduced markedly. In a world in which every major region (US, Euro Area, China) has