The Reserve Bank of India (RBI) is proving to be a Cassandra on inflation. While no rate cut was expected in its first monetary policy of 2017-18 today (6 April), and no cut was indeed delivered, the central bank seems to have built up the inflation threat a bit too strongly.

The Monetary Policy Committee (MPC), which assists the Governor, Urjit Patel, in deciding on rate policies, seems to be happy with groupthink. Even the old technical advisory panel of the RBI seemed to have greater variations in thinking than the MPC. In the last four policies evolved under the MPC structure, the vote has always been 6-0.

For 2017-18, the inflation projections are 4.5 per cent in the first half and 5 per cent in the second half. But the RBI thinks things could get bad.

Among the risks it talks about are the following:

One, the possible shortfall in the south-west monsoon due to the rising probability of the El Nino effect. This is odd, since the Met has talked of El Nino arriving towards the end of the normal monsoon period, which means crops may not be affected much.

Two, there could be a “prominent risk” from the implementation of the house rent allowance (HRA) and other allowances recommended by the 7th Central Pay Commission (CPC). The RBI believes that if the Commission’s HRA recommendations are implemented, “it will push up the baseline (inflation) trajectory by an estimated 100-150 basis points over a period of 12 - 18 months.” The Commission had recommended that HRA should be paid at 24 per cent, 16 per cent and eight per cent of basic, depending on the city of posting. The commission’s HRA recommendations were postponed to this year so that a committee could examine all aspects. But this year is crunch year. However, one wonders if HRA alone will have that big an impact on retail inflation.

Three, there is the goods and services tax (GST) that is to be implemented from July – or latest by September. The RBI says that the GST’s impact on prices could be “one-off”. The chances are the impact will be more in services, where duty setoffs are lower than in manufacturing. Since the price index impact will be one-off, logically its impact should be kept separate from the overall inflation target, especially if this creates a base effect which will pull down prices next year.

Four, the RBI says that the “general government deficit, which is high by international comparison, poses yet another risk for the path of inflation, which is likely to be exacerbated by farm loan waivers.” The concern over farm loan waivers is valid, but the fiscal deficit trajectory has been downwards and non-inflationary under this government. The real risks may, however, surface from GST itself, if the revenues in the first year are not upto the mark, and the centre has to compensate states for any shortfall. This means a higher deficit, but again, as a one-off payment, monetary policy should not be impacted purely by one-off events. GST should settle down to a good rhythm from next year.

The RBI is right to be cautious on inflation, given the various internal and external vulnerabilities, but in a scenario where credit growth has been weak, and bank balance-sheets are stressed due to bad loans, it needs more out-of-the-box thinking on interest rates.

The key to rate cuts is not monetary policy, or even short-term inflationary risks, but bank recapitalisation and the resolution of the bad loans mess.

And the key to higher inflation may well be how the government sets the minimum support prices for kharif crops.