RBI governor says persistently high food prices could lead to spillovers to core inflation

India's economy has been on a strong wicket in the last few quarters. But, retail inflation, although broadly declining, remains a work in progress, especially due to volatile food prices. Global geopolitical and economic uncertainties also pose a risk. Not surprisingly then, the Reserve Bank of India's monetary policy committee (MPC) on expected lines chose to keep the policy repo rate on hold at 6.5 per cent, stressing the importance to bring in food inflation under control.

This is the ninth consecutive time that the central bank has left the rate at which it lends commercial banks unchanged. The MPC also voted in favour of retaining the stance of "withdrawal of accommodation" to ensure inflation progressively aligns to the target, while supporting growth.

"Persistently high food inflation and unanchored inflation expectations – if they materialise – could lead to spillovers to core inflation through pick-up in wages on cost-of-living considerations. This, in turn, could be passed on by firms in the form of higher prices for services as well as goods, especially in a scenario of strong aggregate demand. Third, these behavioural changes can then result in overall inflation becoming sticky, even after food inflation recedes," RBI Governor Shaktikanta Das said in his address on Thursday.

India's CPI (consumer price index) inflation rose to 5.1 per cent in June from 4.8 per cent in May. Food inflation, which has a weight of around 46 per cent in the CPI basket, surged 9.4 per cent.

"The MPC may look through high food inflation if it is transitory; but in an environment of persisting high food inflation, as we are experiencing now, the MPC cannot afford to do so," said Das.

He added that the MPC had to remain vigilant to prevent spillovers from persistent food inflation and preserve the gains made so far in monetary policy credibility.

A degree of relief in food inflation is expected from the pick-up in the southwest monsoon and healthy progress in sowing.

The central bank retained its CPI forecast for 2024-25 at 4.5 per cent. But, it now expects CPI to average 4.4 per cent in the July-September quarter, sharply higher than the 3.8 per cent it had projected in June. Inflation in the December quarter is seen at 4.7 per cent, versus 4.6 per cent earlier and 4.3 per cent in January-March, compared with earlier projected 4.5 per cent.

On the growth front, meanwhile, domestic economic activity continues to be resilient, according to Das. "Household consumption is supported by a turnaround in rural demand and steady discretionary spending in urban areas. Fixed investment activity remained buoyant, amid government’s continued thrust on capex and other policy support. Private corporate investment is gaining steam on the back of expansion in bank credit," he said.

Looking ahead, Das noted that improved agricultural activity brightens the prospects of rural consumption, while sustained buoyancy in services activity would support urban consumption. The healthy balance sheets of banks and corporates, thrust on capex by the government, and visible signs of pick up in private investment would drive fixed investment activity, he said, adding, improving prospects of global trade are expected to aid external demand.

However, there are downside risks from spillovers from protracted geopolitical tensions, volatility in international financial markets and geo-economic fragmentation, he pointed out.

The RBI has retained its GDP growth forecast for the current financial year at 7.2 per cent.

Das noted that India's financial system remained resilient and was gaining strength from broader macroeconomic stability. But, he also observed that with alternative investment avenues becoming more attractive to retail customers, banks were facing challenges on the funding front as deposit growth continued to trail credit growth.

As a result, banks were taking greater recourse to short-term non-retail deposits and other instruments of liability to meet the incremental credit demand, he pointed.

"This may potentially expose the banking system to structural liquidity issues. Banks may, therefore, focus more on mobilisation of household financial savings through innovative products and service offerings and by leveraging fully on their vast branch network," Das advised.

Last year, the central bank had taken several measures, such as raising risk weights, to control the huge growth in unsecured lending. While the sectors where pre-emptive regulatory measures had been taken had shown moderation in credit growth, certain personal loan segments continued to witness high growth, he said.

"Excess leverage through retail loans, mostly for consumption purposes, needs careful monitoring from macro-prudential point of view. It calls for careful assessment and calibration of underwriting standards, as may be required, as well as post-sanction monitoring of such loans," Das stressed.

He also mentioned the brisk pace of growth in top-up housing loans. Banks and NBFCs have also been offering top-up loans on other collateralised loans like gold loans, he pointed, adding that it had been noticed that the regulatory prescriptions relating to loan to value

(LTV) ratio, risk weights and monitoring of end use of funds were not being strictly adhered to by certain entities.

"Such practices may lead to loaned funds being deployed in unproductive segments or for speculative purposes," he said.

Das advised banks and NBFCs to review such practices and take remedial action.

RBI has already taken action against a few NBFCs imposing restrictions on their high margin, but potentially risky gold loans and securities loans in the past few months. With the governor talking tough, will more regulatory action follow against a few more entities or will RBI issue wider guidelines for the sector, is something the industry and investors will be closely watching out for.