RBI’s monetary policy conundrum

The April 6-8 meeting of the Monetary Policy Committee (MPC) of the Reserve Bank of India, the first to be held in the current fiscal, has evoked much interest among analysts, businesses and households. Since the last MPC meet in February, the domestic and global macroeconomic environment has arguably turned more complex.

Back then, the MPC had kept the policy repo rate unchanged (at 4 per cent) and persisted with its ‘accommodative’ stance to facilitate economic revival and growth. Given the challenging macroeconomic environment facing the nation, particularly on the inflation front, the position may no longer be tenable.

The faultlines

A look at the key macroeconomic indicators may be instructive.

First, a March’22 UNCTAD report has downgraded the forecast of India’s growth from 6.7 per cent to 4.6 per cent in 2022. The report attributes the downward revision to various factors, including the Russia-Ukraine war, which could not only impact access to and prices of imported energy products but may also have adverse effects on India, given the growing trade sanctions imposed on Russia.

Second, weakening global demand and elevated debt levels leading to financial shockwaves, recession, or insolvency (as already evident in many countries worldwide) may mean strong headwinds for India’s output growth in general and net exports growth in particular.

In Q3FY22, the current account deficit (CAD) has already sharply widened to 2.7 per cent of GDP. According to CRISIL, CAD shall remain elevated at 2.4 per cent of GDP in FY23 due to high crude oil and commodity prices.

Third, the rising spectre of inflation, driven primarily by rapidly rising food, fertiliser, and energy prices, threatens to play spoilsport in the revival process. While the RBI Governor has consistently downplayed stagflation concerns, an upward revision in the central bank’s own projection of CPI inflation (4.5 per cent in FY23) is inevitable.

As per NSO, retail inflation hit an eight-month high of 6.1 per cent in February, breaching the upper bound of RBI’s flexible inflation target band of 4-6 per cent. Nomura projects that headline inflation will continue to be high, averaging 6.3 per cent y-o-y in the current fiscal. India’s wholesale price inflation at 13.1 per cent in February 2022 could also pose upside risks to CPI as the pass-through occurs in the next 3-4 months.

Fourth, to add to the woes, India’s crude oil basket price, hovering around $118 per barrel (on March 24), has persistently risen — by over 87 per cent since March 2021. India’s recent plan to source cheaper oil from Russia may be ineffective to bring down oil prices as imports from Russia currently account for a minuscule 2 per cent of India’s total crude oil imports.

Various estimates suggest that a $10/barrel increase in crude oil prices will add 24 bps directly and 26 bps indirectly to CPI, and increase CAD by up to 0.4 per cent of the country’s GDP. With wages not indexed to prices for a majority of the employed, persistently high inflation levels may subdue consumer sentiments, erode the purchasing power of households, and dent business confidence — collectively depressing aggregate demand.

Fifth, the rupee, which has fallen 3.5 per cent against the dollar in 2022, is likely to face further pressure due to a rising CAD and the Fed’s expected tightening trajectory this year. Despite a comfortable level of forex reserves, estimates suggest that the USD/INR pair may still touch the 79 mark over the next three months. The pass-through effect of a sharply depreciating rupee on domestic inflation can make inflation broad-based, thus accentuating the headache for RBI.

The above factors clearly suggest that the currently precarious growth-inflation trade-off poses a difficult policy conundrum for India’s central bank. Nevertheless, despite the concerns of sluggish growth, RBI needs to turn hawkish, albeit in a calibrated manner. Why so?

Growth worries

First, mounting inflationary pressures will surely hurt medium-term real income and growth prospects if not attended to at the earliest. The latest available data suggests that the y-o-y nominal growth of rural wages has flattened to 5.2 per cent for agricultural workers and 4.2 per cent for non-agricultural workers in January 2022. Adjusted for rural retail inflation of over 6 per cent, real wage growth for both groups has already turned negative, with attendant consequences on rural and aggregate demand.

Second, the Federal Reserve has already hiked the US interest rate by 25 basis points in March, and has indicated a series of hikes in the coming quarters. Actions of the central banks in Europe and other emerging market economies suggest a similar tightening cycle. The RBI can ill-afford to play the catch-up game on rate hikes aggressively later, as the economy’s bandwidth to absorb sharp and sudden shocks is extremely limited under the current fundamentals.

Third, while fiscal and supply-side measures may be more potent to tackle a supply-shock induced inflation, the prolonged nature of the shock may lead to spiralling out of inflationary expectations. With the headline inflation above the upper tolerance band, it is imperative for the central bank to signal and implement steps to prevent the de-anchoring of expectations.

A monetary policy misstep at this stage will again land on the central bank’s door sooner than later in a more complex form. Further, sticking with the status-quoist approach may seriously dent RBI’s credibility, particularly if it fails to uphold its stated inflation targeting policy.

It is time for the RBI to recall its primary mandate (that of maintaining price stability) and turn a bit hawkish at this juncture!

The writer is Assistant Professor in the Economics Area at the Indian Institute of Management (IIM) Ranchi. Views expressed are personal

COMMENT NOW