India’s central bank hikes policy rate for the first time in Modi era

Looking for green shoots.
Looking for green shoots.
Image: Reuters/Shailesh Andrade
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India’s central bank today (June 06) increased the benchmark interest rate for the first time in four and a half years.

The repo rate, the interest at which banks borrow money from the Reserve Bank of India (RBI), has been increased to 6.25% from 6%. This hike, the first since the Narendra Modi government took charge, is likely to lead to higher lending rates for borrowers.

Despite the interest rate hike, which usually drags markets down, the Sensex gained nearly 1% soon after the announcement. That’s because the RBI painted a fairly encouraging picture of the world’s fastest-growing major economy, in spite of the rising risk of inflation. The central bank has retained the full-year economic growth forecast at 7.4%.

Nonetheless, the biggest driver for the hike in the interest rate is rising inflation in the country. “While the summer momentum in vegetable prices was weaker than the usual pattern, there was an abrupt acceleration in CPI (consumer price index) inflation excluding food and fuel,” the RBI statement said. “This, along with an increase in other global commodity prices and recent global financial market developments, has resulted in a firming up of input cost pressures.” A hike in the interest rate reduces money supply and curbs demand, leading to lower prices.

The RBI increased its projection for inflation by the end of the current financial year by 30 basis points, compared to its earlier estimate in April.

One of the biggest factors fuelling inflation in India is the recent spike in the price of crude oil, which India imports in copious quantities to meet its domestic needs. The RBI statement noted that the “12% increase in the price of Indian crude basket (in April), which was sharper, earlier than expected and seems to be durable.”

There is also uncertainty over how the government’s proposed hike in minimum support prices (MSP) will impact food prices. “The impact of the revision in the MSP formula for kharif (July to October) crops is not possible to assess at this stage in the absence of adequate details,” the statement said.

The risk from inflation notwithstanding, the Indian central bank has said that the economic revival is on a strong footing. “Investment activity, in particular, is recovering well and could receive a further boost from swift resolution of distressed sectors of the economy under the Insolvency and Bankruptcy Code,” the monetary policy statement said.

The rupee, Asia’s worst-performing currency this year, extended its gains soon after the announcement. The pullback in the Indian currency, welcome in the face of rising inflationary pressures, began earlier in the day, propelled by the market’s expectation of an interest rate hike.

Experts believe the move by the RBI is better late than never. “Raising rates is a right move,” NR Bhanumurthy, an economist at the National Institute for Public Finance and Policy told Bloomberg. “Given the international conditions—rising oil prices, the Fed’s rate policy, and the fact that other emerging markets have already begun raising rates—RBI should have probably raised rates earlier.”