Insure Now or Wait and See: The RBI's Choice Between Anchoring Prices and Protecting Growth

Growing Well, With Price Risks Rising: Should the RBI Act Before Inflation Does? The

RBI faces a real dilemma. The economy is strong now: global agencies project growth of about 7%, industrial output rose 6.3% in April-July and government capital spending almost 30%. But the likely sources of higher prices, a weak monsoon, El Niño and conflict in West Asia pushing up energy costs, are shocks to supply that interest rates cannot directly fix.

Should the central bank raise rates now or wait?

The Case for Raising Rates Now

The strongest argument is about real interest rates, meaning the policy rate minus expected inflation. The repo rate stands at 5.25%. S&P expects inflation to average 5.1%. That leaves a real policy rate of roughly zero while the economy grows at about 7%.

By any standard, that is loose policy. Food risks are building. Rice prices are already 7-8% higher than a year ago and El Niño is expected to last into early 2027, threatening the winter wheat crop. Food price rises that persist tend to raise inflation expectations among households and workers, who then push for higher wages and prices.

That process is harder to reverse later than to prevent early. India has seen this happen. In 2022, the RBI started raising rates only in May, with an unscheduled hike and then needed six consecutive hikes, a total of 250 basis points, to catch up.

Acting a little now may avoid having to act a lot later.

The Case for Holding

The opposing argument is also strong. Agencies expect growth to slow in the second half as the boost from tax cuts fades. The OECD sees weaker momentum before recovery in 2027. Raising rates into a slowdown could make it worse.

The inflation forecast of 5.1% is still within the RBI's tolerance band of 2-6%. The pressure comes mostly from food and weather and higher interest rates do not make it rain. Tightening policy against a supply shock can mean giving up growth without much effect on prices.

TAN's Position

TAN's position is that the RBI should raise the repo rate by 25 basis points in October, as a one-off measure of insurance and keep its neutral stance. It should say plainly that this is not the start of a series of hikes.

The deciding factor is the near-zero real rate. Holding rates would be defensible if policy were already tight. It is not. A small hike now takes out insurance against inflation expectations rising at a relatively low cost, while growth is strong enough to absorb it.

Keeping the stance neutral limits the damage if the slowdown in the second half proves deeper.

What would change our view: if food prices clearly ease after the harvest and the second-quarter data show a sharp slowdown, a hold would be the better choice.

For the exam: when inflation comes mainly from supply shocks, monetary policy cannot fix the cause, but it can stop the shock from spreading into expectations. The level of the real interest rate usually decides how much room the central bank has.