The RBI Needs to Raise Rates More to Regain Credibility

In trying to squeeze one last drop of output from an empty barrel of monetary elixir, India’s central bank made the serious mistake of not only ignoring the country’s inflation buildup, but pretending that it didn’t exist. Now that the Reserve Bank of India has surprised the market with an unscheduled, 40 basis point increase in the benchmark rate, the journey to recoup its lost credibility is finally under way. Chances are, it will be a hard slog. While the tightening campaign is unavoidable, the longer it goes on, the more it will annoy politicians.

Even the U.S. Federal Reserve seriously underestimated the inflation risk last year, and has to play catch-up. The RBI’s policy errors are more recent. The central bank blew its February meeting by projecting price increases for the financial year ending in March 2023 at a benign 4.5%. The monetary policy committee put its faith behind that cheery forecast even though the bond market didn’t believe it one bit: Private-sector estimates were by then already starting to coalesce around the top end of the central bank’s 2%-6% target inflation range. Still, traders took the official forecast as a signal that the RBI was going to ignore price pressures just to keep borrowing costs low for the government and give a helping hand to a still-incomplete recovery from Covid-19.