RBI’s accommodative stance has been justified

Also, since the private sector is investing little, it is important the Centre and the states are able to borrow and invest.

RBI Governor Shaktikanta Das’s comments at the MPC meeting earlier this month make it clear the central bank was all for supporting the nascent economic recovery. Deputy Governor Michael Patra too had argued policy choices had shifted towards increasing accommodation. During the policy announcement, the Governor had reassured the bond markets that liquidity would remain adequate, saying there was no question of tightening monetary just yet. Since then, the US Federal Reserve has brought forward projections for rate hikes, with Fed chair Jerome Powell acknowledging inflation could turn out to be “higher and more persistent than we expect”. Now, 11 FOMC members are looking for two rate hikes in 2023, with seven seeing a hike as early as 2022; in March, the median was for a hike only in 2024.

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More pertinently, inflation in India too has moved up. RBI will soon need to rethink its stance because it cannot afford to remain an outlier for too long when other central banks are signalling a retracement from an accommodative policy. While RBI’s primary mandate is to target inflation, it has, since the pandemic broke out, maintained an accommodative stance even though inflation was above 6% for much of 2020. Although inflation did rise above 6% for two quarters last year, it dipped back below 6% thereafter. That the central bank has not altered its stance yet—and has asserted, in no uncertain terms, that growth is the top priority—is both understandable and acceptable. Exceptional times call for exceptional policy approaches. Setting aside the core objective of inflation-control to resuscitate a struggling economy is more than justified. Also, since the private sector is investing little, it is important the Centre and the states are able to borrow and invest.

But retail inflation hit 6.3% in May, above the tolerance level of 6%, driven up by food, imported fuel inflation, and critically, elevated and broad-based core inflation—which jumped to 6.7%, driven perhaps by higher commodity prices and also perhaps inflationary expectations. Inflation hurts the poor. They may not use petrol, but rising diesel prices have cascading impact on prices of other goods. While the economy should spring back in FY22—consensus estimates peg growth at about 8.5-9% of GDP—aggregate demand is unlikely to bounce back meaningfully, given the toll that the second wave of the pandemic has taken on the relatively better-off households. Thus, chances of a demand-pull adding to the supply-side impetus, to push up prices further, are relatively modest. Nonetheless, economists believe prices in India tend to be rigid on the downside and, therefore, only a part of the price rise will reverse when the economy opens up over the next few months.

As of now, it appears RBI will need to start tightening monetary policy towards the end of 2021. Until then, it can afford to stay accommodative; it will be called to offer an explanation only if inflation persists at above 6% for three quarters in a row. As such, the commentary is unlikely to turn hawkish in August, but the tone might change in October if the rise in prices doesn’t reverse. In the meantime, RBI would be watching for early signs of a second-round passthrough in inflation. Higher interest rates may not hit investments much; in any case, there is very little greenfield investment taking place. But smaller businesses will be hurt once banks raise lending rates and, the government’s borrowing costs will go up. But inflation can’t be allowed to get entrenched.