Why inflation-fighter Raghuram Rajan did not raise the repo rate

Raghuram Rajan, the governor of the Reserve Bank of India (RBI) surprised everybody today, by choosing to not raise the repo rate. The repo rate will continue to be at 7.75%. Repo rate is the rate at which the RBI lends to banks.
Economists had been predicting that Rajan will raise the repo rate in order to rein in inflation. The consumer price inflation(CPI) for the
 month of November 2013 was at 11.24%. In comparison the number was at 10.17% in October 2013. The wholesale price inflation(WPI) number for November 2013 came in at 7.52%. In comparison the number was at 7% in October 2013.
As Taimur Baig and Kaushik Das of Deutsche Bank Research wrote in a note dated December 16, 2013 said “The upside surprise in both CPI and WPI inflation for November leaves no option for RBI but to hike the policy rate(i.e. the repo rate) by 25basis points in Wednesday’s monetary policy review, in our view.”
Along similar lines Sonal Varma, India economist at Nomura, told CNBC.com that she expected the RBI to increase the repo rate by 25 basis points(one basis point is one hundredth of a percentage). But Rajan has chosen to stay put and not raise the repo rate.
Why is that the case? The answer lies in looking at the inflation numbers in a little more detail. The consumer price inflation is primarily being driven by food inflation. Food (along with beverages and tobacco) accounts for nearly half of the index. Food inflation in November 2013 as per the CPI stood at 14.72%. Within food inflation, vegetable prices rose by 61.6% and fruit prices rose by 15%, in comparison to November 2012.
So what this tells us very clearly is that consumer price inflation is being driven primarily by food inflation. In fact, this is something that the WPI data also clearly shows. The food inflation as per WPI was at 19.93%. Within it, onion prices rose by 190.3% and vegetable prices rose by 95.3%.
The RBI expects vegetable prices to fall. Baig and Das in a note dated December 18, 2013, said “vegetable prices, key driver of inflation in recent months, have started falling in the last couple of weeks (daily prices of 10 food items tracked by us are down by about 7% month on month(mom) on an average in the first fortnight of December).”
In case of WPI, food articles have a much lower weightage of around 14.33%. The other big contributor to WPI was fuel and power, in which case the inflation was at 11.08%. This is primarily on account of diesel and cooking gas prices being raised regularly in the recent past.
So inflation is primarily on account of two counts: food and fuel prices going up. The Reserve Bank of India cannot do anything about this. And given that raising the repo rate would have had a limited impact on high inflation.
In fact, if one looks at the WPI data a little more carefully, there is a clear case of the economy slowing down. Manufactured products form a little under 65% of the wholesale price inflation index. The inflation in case of manufactured products stood at 2.64% in November 2013.
When people are spending more and more money on buying food. They are likely to be left with less money to buy everything else. In this scenario they are likely to cut down on their non food expenditure.
And this has an impact on businesses. When the demand is not going up, businesses are not in a position to increase prices. And that is reflected in the manufacturing products inflation of just 2.64%. It was at 5.41% in November 2012.
Interestingly, the high cost of food should translate into the cost of labour going up. At the same time, energy prices are also going up. This is reflected in the fuel and power inflation of 11.08%. But businesses have not been able to pass through these increases in the cost of their inputs, by raising the price of their final products. This is primarily because of the lack of consumer demand.
The lack of consumer demand is also reflected in the index of industrial production(IIP), a measure of industrial activity. 
For October 2013, IIP fell by 1.8% in comparison to the same period last year. If people are not buying as many things as they used to, there is no point in businesses producing them.
In this scenario, raising interest rates would mean that people looking to borrow and spend money to buy goods, will have to pay higher EMIs. Businesses looking to borrow money and expand will also have to pay more. And this turn impacts economic growth. As the RBI’s statement today put it “The weakness in industrial activity persisting into Q3, still lacklustre lead indicators of services and subdued domestic consumption demand suggest continuing headwinds to growth.”
In this scenario the Rajan led RBI decided to keep the repo rate constant. What is interesting is that the RBI’s statement has suggested that it might raise the repo rate if the food inflation does not fall as it is expected to. “If the expected softening of food inflation does not materialise and translate into a significant reduction in headline inflation in the next round of data releases, or if inflation excluding food and fuel does not fall, the Reserve Bank will act, including on off-policy dates if warranted,” the statement said.
Effectively, the RBI has bought some time. “
The RBI has effectively given itself a one-month window to see if inflation actually eases in December to decide on future monetary policy action,” wrote Baig and Das of Deutsche. 
In fact, Raghuram Rajan’s decision not to raise the repo rate has been seen as a surprise primarily because he has made several comments in the public saying that inflation was running higher than the comfort level. Also, Rajan is seen as an inflation fighter, and by not raising the repo rate, he has put that image at risk.
As Robert Prior-Wandesforde, director of Asian economics research at Credit Suisse, recently wrote “The data pose the now familiar dilemma for the central bank. While the direct effect of interest rate hikes on inflation is debatable, particularly when food prices are such an important driver, we very much doubt Dr. Rajan can be seen to be sitting on his hands at this stage …”To do so, would be take risks with his inflation fighting credentials,” he added.
It is hard to believe that Rajan will these credentials at risk. And given that we might just see a repo rate hike early in the new year.
The article originally appeared on www.firstpost.com on December 18, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek)