An archer’s perspective of the Reserve Bank’s monetary policy
PremiumShould RBI try to tackle every economic issue in the near term or focus squarely on easing inflation?
In a popular incident in India’s much loved epic, the Mahabharata, a master teacher, while teaching his royal students archery, asks them to take a shot at the eye of a wooden bird propped up on a tree. He asks each of his students what they are able to see while taking the shot. Most reply that they see the bird, the leaves and the distant sky. Finally, one student says that all he can see is the eye of the wooden bird. The teacher is suitably impressed with his focused student, who unsurprisingly grows up to be a master archer.
This story has parallels with India’s post-pandemic economy. There is a lot going on. Inflation is uncomfortably high, growth is recovering, new supply shortages are emerging, India’s twin deficits are widening, and the rupee has been volatile. Should the Reserve Bank of India (RBI) focus on each of these in its policies over the next few months, or should it have a singular focus on easing inflation?
We believe that for several reasons, there is a case for focusing on inflation control.
One, higher-for-longer inflation can hurt other parts of the economy. Take small firms, which employ about 40% of India’s labour force and are the weakest link in India’s recovery. Even before they had recovered fully from covid lockdowns, they were hit by a commodity price shock. These small firms haven’t become as energy efficient as large firms have, and neither do they have as much bargaining power when buying raw materials. A Nielsen survey estimates that the number of small firms has shrunk by 8% since March 2020.
In one possible scenario, high inflation could lead to higher fiscal spending and a wider deficit if demand for social welfare schemes rises. In another scenario, it could also lead to a wider trade deficit if consumers bring forward purchases over fears that prices will head even higher later. Finally, high inflation fears can also add an inflation risk premium to bond yields and weigh on the rupee.
Two, some of the inflationary pressures building up have yet to show up in prices. While much of India’s food inflation is driven by domestic factors like monsoons, some of it is also driven by international food prices. Yet, so far only half of the regular pass through from global to domestic food prices has transpired. As the pass through gathers pace, domestic food prices could rise further.
Alongside this, while makers of goods have been proactive in passing through input cost increases to consumers, the services industry has been more hesitant. But as service providers like restaurants start adjusting their menu costs, inflationary pressures will increase. Similarly, rural prices have risen quicker than urban prices. As electricity tariffs, which impact urban inflation more, are raised, urban inflation will also begin to rise.
Three, India’s inflation rate may not dip as soon as commodity prices begin to fall. We worry that prices may be a little sticky for a variety of reasons. Large corporates have gained pricing power through the pandemic. When input costs fall, will they cut prices of the goods they sell as quickly as they raised them? Long agricultural cycles and gradual adjustments in electricity tariffs could also keep inflation sticky.
For all these reasons, inflation is likely to remain higher than RBI’s 4% target for a substantial period.
We think the policy implication is clear—that RBI delivers a series of policy rate hikes. Following the 40 basis point repo rate hike in May, we expect another one in June, taking the repo rate to 4.8%. Thereafter, we expect a series of smaller-quantum rate hikes, taking the repo rate to 6% in mid-2023. Our one-year ahead inflation forecast is 5.5% (in 2023-24), and a repo rate at 6% would mean that the real policy rate is at a positive 0.5%, which we believe would be appropriate (our sense is that real neutral rates are in the 0.5-1% range).
A couple of dos and don’ts may come in handy along the way. The growth recovery is strong currently, led by a wave of pent-up spending on services. It may be relatively easy for the Indian economy to digest rate hikes in quick succession right now. No use delaying or taking breaks.
It may also be a good idea to focus squarely on inflation control in the policy statement—detailing the inflation problem and various instruments to counter it. Other actions like any government bond purchases should probably be kept outside the policy day statements. A sense that RBI is on a war-footing with regard to inflation will likely do a lot in bringing down inflation expectations.
As for the don’ts, we should not claim victory over inflation when the first annual number comes down. Some inflation prints will be influenced by base effects. Instead, we should keep looking at the sequential momentum with as much vigour. The May inflation reading will be a case in point. Even if the annual reading falls from 7.8% year-on-year in April to 6.9% in May, like we expect, the sequential reading will still be elevated at 11% quarter-on-quarter seasonally adjusted, annualized.
With the inflation problem clearly taking centre stage, an archer’s focus can help reach the optimum macro outcome.
Pranjul Bhandari is chief India economist at HSBC