Major central banks of the developed countries by and large pursued easy monetary policy since the global financial crisis (GFC) in 2008. Pursuing accommodative monetary policy for such a long time has pre-empted central banks in creating the policy space. When the Covid-19 pandemic struck in early 2020 there was no option but to inject as much liquidity as possible besides large fiscal support wherever fiscal space was available to safeguard their economies from collapsing.

The ultra-accommodative monetary policy buoyed asset prices quickly rather than stimulate output growth. Post-pandemic, the global recovery in 2021 was sharp from a low base, but the momentum had slowed even before the Russia-Ukraine conflict.

According to the January 2022 update of the IMF’s World Economic Outlook (WEO), the global output growth is expected to moderate from 5.9 per cent in 2021 to 4.4 per cent in 2022 — 50 basis points lower than IMF’s October 2021 projection. The revised projection has already come under a cloud, thanks to the Russia-Ukraine conflict, disruption in capital flows, and likely decline in global trade volume.

When growth impulses are strong, upside risks to inflation are typically high. In such situations, demand management by central banks works perfectly well to tame inflationary pressures as growth might be well above the potential. Notwithstanding the clear mandate, central banks face a severe dilemma in balancing between growth and inflation given the upside risks to inflation and downside risks to growth.

The world economy is currently passing through such a growth-inflation configuration. The downside risks to growth have been accentuated globally for multiple reasons — low investment, high input costs, and productivity slowdown. The armed conflict between Russia and Ukraine and disruption in the supply chain/capital flows also weigh on global recovery.

Wester nations are facing their highest inflation in several decades as a fallout of the extra-loose monetary policy pursued for a long period besides pandemic-related supply disruption.

The situation is unlikely to improve soon due to rising international commodity prices, particularly crude oil prices and geopolitical risks. The arguments that the current inflation is a supply-side phenomenon and therefore transitory in nature, have lost their relevance. With high core inflation, the inflationary pressures have been generalised. Hence, central banks have very little policy space to support growth anymore.

Can central banks be aggressive in controlling retail inflation given their mandate? Inordinate delay in normalising monetary policy is likely to flare up inflation further, which may anyway harm growth going forward. Even a tightrope walk by central banks to balance between growth and inflation would increase inflation expectations. Central banks in the United Kingdom, South Korea, New Zealand, Russia, South Africa, Argentina, and Brazil have raised policy rates in 2021 and 2022 so far. As the US retail inflation in February 2022 was at a four-decade high at 7.9 per cent, the US Fed also hiked its policy rate by 25 basis points on March 16, 2022. Seven such hikes are expected this year.

Indian scenario

The Indian scenario is more or less similar to that of the global situation. Growth is yet to be fully market-driven. Compared to many other nations, India’s recovery at 8.9 per cent in FY22 looks robust against the low base. Adjusted for the base effect, real GDP growth in FY22 may be hardly 1.5 per cent above the real GDP level achieved in FY20. Both consumption and private investment remain subdued. The government's high capital expenditure is yet to crowd in private investment. The RBI’s projection of 7.8 per cent growth in FY23 has been facing both domestic and global headwinds.

The Russia-Ukraine conflict and high crude oil prices are the two immediate factors contributing to upside risks to inflation. India’s retail inflation is likely to overshoot the RBI’s latest inflation projection of 4.5 per cent in FY23. Although the output gap is still negative, it would be difficult for the Monetary Policy Committee to pursue accommodative monetary policy any longer.

Inflation control being the overriding objective of monetary policy under the flexible inflation targeting regime, it would be difficult for the MPC to credibly communicate accommodative monetary policy stance in the current situation.

In a situation of excess liquidity, the reverse repo rate becomes the effective policy rate. In the overnight segment, the weighted average rate was even below the reverse repo rate of 3.35 per cent for about a year (November 2020 to November 2021), which rose considerably to around 3.75 per cent by March 10, 2022.

The draining out of excess liquidity has been gradual — about ₹1 trillion — mainly through sales of domestic and foreign assets. Currently, the RBI is facing the dilemma of managing a large government borrowing programme, which cannot sail through smoothly at competitive yield if liquidity condition is tightened aggressively.

Policy suggestions

Since the effective corridor is now narrowed, there is no reason as to why the reverse repo rate cannot be raised to 3.75 per cent — repo minus 25 basis points and the corridor restored. A neutral monetary policy stance at this stage is likely to do the least damage to India’s GDP growth.

Keeping the accommodative monetary policy stance for a long period is untenable as inflationary pressures are being generalised with both headline and core inflation remaining elevated. There is also an opportunity available to drain out excess liquidity by selling foreign exchange when the rupee is under pressure.

The fiscal policy has been pro-growth and therefore there are valid reasons to suggest another pro-growth measure — reduction in fuel taxes by both central and State governments to neutralise the adverse impact of the rise in international crude oil prices on domestic inflation and growth. This may result in revenue loss, particularly to the Central government, which may be offset by the recent tax buoyancy.

The writer is RBI Chair Professor at Utkal University, Bhubaneswar, and former Principal Adviser/Head of the Monetary Policy Department of RBI. Views expressed are personal