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In trying to squeeze a last drop of production from an empty barrel of money elixir, India’s central bank has made the grave mistake of not only ignoring rising inflation in the country, but also pretending that she didn’t exist. Now that the Reserve Bank of India has surprised the market with an unanticipated 40 basis point hike in the benchmark rate, the journey to regain its lost credibility is finally underway. Chances are it’s hard work. Although the tightening campaign is inevitable, the longer it lasts, the more it will annoy politicians.

Even the US Federal Reserve seriously underestimated inflation risk last year and needs to catch up. The RBI’s policy mistakes are more recent. The central bank spoiled its February meeting by forecasting price hikes for the fiscal year ending March 2023 at a benign rate of 4.5%. The monetary policy committee relied on this cheering forecast, even though the bond market didn’t believe it at all: private sector estimates were already starting to consolidate around the upper end of the inflation target. from 2% to 6% of the central bank. Scope. 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 lend a hand to a still incomplete recovery from Covid-19.

However, by the time February inflation hit 6.1% – higher than the previous month’s 6% and outside the tolerance range – Russia’s invasion of Ukraine had begun. If the RBI was behind the curve before the war, it was nowhere near being on track after it.

After consumer prices rose nearly 7% year-over-year in March, Nomura Holdings Inc. raised its forecast for rate increases by the third quarter of 2023 to 200 basis points , against 150 basis points. The final rate for the RBI repo rate would be 6%, economists Sonal Varma and Aurodeep Nandi said. After Wednesday’s increase, which took India’s benchmark to 4.4%, Nomura changed its terminal rate estimate to 6.25% by the second quarter of next year. The longer you delay normalization, the more you end up doing.

Prime Minister Narendra Modi’s government won’t like short-term rates going up to 6.25% because it could mean long-term sovereign bond yields of 8% or more, which India doesn’t has not seen in a lasting way since the consequences. from the 2013 taper tantrum. (The 10-year yield jumped to nearly 7.4% after the RBI’s unexpected move.) Higher interest rates could make it harder to fund a record government borrowing program $200 billion, larger than even in the first year of the pandemic. Costlier capital could also pour cold water on a recovery in private investment that policymakers have been desperately waiting for.

It’s catch-22. Trying to fuel weak demand with artificially low rates could ultimately threaten external stability. So far this year, foreign investors have withdrawn more than $17 billion from the Indian stock market. The $600 billion in foreign exchange reserves could shield the currency from the intense selling pressure it witnessed after the Fed cut in 2013. Even so, a growing current account deficit, combined with the reluctance of the RBI to raise rates, hasn’t exactly inspired confidence in rupee assets. The Nifty index of the top 50 stocks was trading at 22 times forward earnings at the start of the year; that valuation has since declined to 19 times earnings. Yet global investors refuse to bite.

Inflation hurts the poor and middle class more than the rich. It also squeezes the small business which is not able to absorb the higher commodity costs in the same way a large business can by sacrificing overhead. Many small and medium-sized businesses in India have only survived the pandemic with the help of government-backed emergency loans. Now that the RBI has stopped denying prices, the most vulnerable producers and consumers will expect it not to stop prematurely. Let the government do its best to protect growth while managing its finances. The central bank needs to start fulfilling its inflation mandate again.

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This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Andy Mukherjee is a Bloomberg Opinion columnist covering industrial companies and financial services. He was previously a columnist for Reuters Breakingviews. He has also worked for the Straits Times, ET NOW and Bloomberg News.

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