7th pay commission HRA allowance: This will give sleepless nights to RBI on inflation target? RBI Monetary Policy today

7th pay commission HRA allowance: The Reserve Bank of India (RBI) has always indicated its concern when it comes to the 7th pay commission based salary and allowance hikes and their impact on CPI inflation that affects all of India. The fear of 7th Pay Commission HRA allowance was such that RBI maintained status quo for quite some time, until things got worse and the central bank was forced to hike interest rates between June to August 2018 policy, something that is not considered good for the public at large, the borrowers or the industrialists, as it makes loans more expensive. 

However, much to the relief of central government employees and others, many analysts believe that the impact of HRA allowance would not be much, and RBI will manage to overcome inflation problems.

Retail Inflation in October 2018 month came in at 3.3% lower compared to 3.8% in September 2018 and 3.6% a year ago same month. Lower inflation was an outcome of food inflation which continued to decline largely led by sharp contraction in pulses, vegetables and fruits, fuel inflation continued to rise, tracking international oil prices. 

Currently, RBI's policy repo rate stands at 6.50%. 

Consumer price index (CPI) inflation is the headline measure used by the Reserve Bank of India (RBI) for the conduct of monetary policy. In terms of the provisions of the RBI Act, the target for headline inflation is 4 per cent with a tolerance band of +/- 2 per cent. 

source: tradingeconomics.com

RBI said, "The current experience is not one off. Such large increases have in past too pushed up inflation significantly. The past effect of 7th pay commission HRA awards on inflation is available only from CPI for industrial workers (CPI-IW) produced by the Labour Bureau since CSO’s CPI did not exist then. To assess this impact, CPI-IW is reconstructed by substituting the observed housing index with an estimated housing index using pre-CPC housing momentum of the immediate preceding three years."

It added, "Since the housing index in CPI-IW is adjusted once in every six months, unlike headline CPI, the impact was not gradual but came as step increases – first in January 2018 and then July when the housing index is reset. Due to higher weight of housing, the impact of HRA revision was much higher in CPI-IW."

Following the 7th pay commission HRA award, the share of housing in CPI-IW inflation rose in January 2018 and gained substantial proportion by July-August 2018. Adjusting for the HRA effects, the July and August print of CPI-IW inflation at 5.6 per cent was markedly lower at 1.7 per cent. 

In the past, using this approach, it is seen that CPI-IW inflation was pushed up by 200 and 400 basis points following the 5th and 6th pay commissions, respectively. 

Hence, RBI believes that the 7th Pay commission HRA allowance risk. 

Talking about today's policy, Teresa John Research Analysts at Nirmal Bang said, "While there have been some concerns on the measurement of housing inflation, the statistical impact of the increase in house rent allowance for central government employees has largely waned. Moreover, the recent increase in core CPI inflation mostly stemming from household and personal goods, reflects the impact of increase in customs duty and the lagged impact of INR depreciation."

John added, "With the recent decline in petrol and diesel prices and stability in the INR, core CPI inflation is likely to edge downwards from the current level, but may persist in the 5.5-6% range. In our view, the recent increase in core inflation does not warrant an immediate rate hike, and the RBI would rather adopt a wait-and-watch approach. We continue to factor in a rate hike by June 2019 as inflation edges closer to 5%."

Core CPI inflation edged up to 6.2% in October 2018 from 5.8% in the previous month, which, as far as RBI Governor Urjit Patel is concerned, warrants vigilance.