A test looms for RBI on its targeting of inflation
PremiumIts status quoist monetary policy raises the risk of falling behind the curve on price stability, a key mandate. As having to play catch-up later could prove costly, RBI should stay alert
With inflation an alarm in major economies of the rich world, ultra-easy money has begun being staunched by their central banks. Given a mix of likely spillover effects and local pressures on what each rupee can buy, the Reserve Bank of India (RBI) was expected to act in favour of price stability with policy tweaks to fend off those threats. On Thursday, it left its repo rate of bank funding unchanged at 4%, as decided by its Monetary Policy Committee, a level to which this rate was reduced in May 2020 to ease credit in response to the covid crisis. To wide surprise, however, RBI also held its reverse repo rate—at which it absorbs money from India’s banking system—steady at 3.35%, even though conditions in our money market and its own variable-rate reverse repo settings had argued for this rate to be upped. While RBI retained its overall ‘accommodative’ stance, a signal of staying in easing mode, it also made it clear that it would continue its use of other tools to squeeze excess liquidity, as it has been doing for a few months. Broadly speaking, the status quo is set to prevail for now, a sign that the fragility of our economic recovery was judged by policymakers to outweigh the risk of a price flare-up ahead.
After a price scare in the latter half of 2020, monthly readings of retail inflation have stayed mostly within RBI’s 6% upper limit of tolerance over the past year, though they printed above its central target of 4%. While the economy’s need for credit support must have made a mid-band target too much of a stretch for RBI, its dovish approach has also made it likelier that it will get caught behind the curve of a price surge. Will it? By RBI’s estimates, our economy is poised to grow 7.8% in 2022-23 with inflation projected at 4.5%, which would mean faster nominal growth than what the Union budget projects. Confidence in any of these numbers could vary as the year unfolds, but it’s the price-index variable that would likely be subject to the most volatility. Various assets look inflated right now, even as sundry trends imply multiple risks. Inelastic imports of dearer crude oil globally could combine with a weaker rupee to raise fuel costs, for example, while the use of our dollar reserves as a currency prop would enforce other tricky trade-offs. Rising input costs have seen retail tags marked up by a wide range of businesses, lately, a trend that might strengthen. Even if supply-chain setbacks are no longer a big worry, a robust revival of private consumption from an extended slump could also push demand ahead of what’s available. By RBI’s forecast, however, demand and supply will largely stay on an even keel.
Would an easy-money pullback have been premature at this point? Perhaps. But we can’t be sure. Extra-cheap credit usually needs to be withdrawn once such a stimulus has done its job. Else, excess money can show up in prices. Though RBI’s rate play on short-tenor debt may be taken as a prelude to policy normalization, a substantive shift held off for later seems too risky for comfort. Note that RBI also happens to be our manager of public debt, a burden that’s already very heavy, with a large fiscal deficit yet to be financed. Gates opened further for more inflows into domestic bonds could help calm market nerves (and yields). Still, RBI’s control of prices, as required by its price-stability mandate of 2016, will probably be put to a stiff test by what the future holds. How well it ensures our rupee retains its real value will be under watch.
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