At first glance, the case for monetary tightening appears straightforward. Headline inflation is set to rise sharply, oil and food prices have risen, and growth is resilient. This could imply an overheating economy and a central bank behind the curve, but that would be the wrong conclusion.

A different starting point

There are two reasons why the current inflation episode is different from the past. First, India’s trend inflation has declined considerably. Our estimates suggest that the super-core inflation trend has fallen from 5 per cent during 2015-23 to 3 per cent currently.

Second, inflation is not generalised. Measures of underlying inflation have risen from their lows, but remain contained. In August, 63 per cent of the CPI basket was still recording inflation of 4 per cent or less, based on a weighted diffusion index. Our composite inflation generalisation index — combining inflation momentum, diffusion, expectations and wages — remains below its historical average.

Why have second-round effects not materialised, even seven months after the Iran war? We believe that firms have limited pricing power, past margin and efficiency gains have provided a buffer to absorb higher costs, while inflation expectations are well-anchored due to the flexible inflation targeting regime; all of these factors have played a role.

Rising cyclical pressures

However, there is no room for complacency. Cyclical inflation pressures are building. Food is the most immediate risk, with deficient rainfall and weaker crop production pushing up prices of cereals, sugar, milk, pulses and edible oils.

Also, although the pass-through from higher commodity prices to consumers has so far been low, there is a risk of an eventual pass-through, considering the sustained cost shock. Our pass-  through analysis shows there is a 2-3 quarter lag between input costs and output prices. If so, monetary policy needs to anchor expectations pre-emptively.

One could argue for waiting, since inflation has not generalised, but monetary policy is most effective when it is pre-emptive. A small adjustment now provides insurance against inflation risks and builds policy buffer amid global uncertainty.

This cycle is also very different from 2022. Then, growth was recovering, core inflation was above 6 per cent and broad-based, and the policy rate was well below neutral. Now, growth appears resilient but not yet self-sustaining, core inflation is only a shade above 4 per cent, and the policy rate is already close to neutral. Thus, a modest rate increase would be a recalibration, rather than the beginning of a conventional tightening cycle.

There is also an operational dimension. For the repo rate to remain an effective signal, the weighted average call rate needs to be aligned with it. Further liquidity withdrawals via OMO sales and FX sell-buy swaps should complement any rate recalibration. The appropriate response is therefore a measured recalibration: Anchor expectations, improve monetary transmission and retain flexibility. The RBI may need to do something now precisely so that it does not have to do much more later.

Sonal Varma is a chief economist (India and Asia ex-Japan) at Nomura