RBI Monetary Policy: Growth Concern Overrides Inflation Worry
The MPC has assured to stay the monetary course if inflation pans out, but it is for the government to ensure this is achieved!
For the first time, the monetary policy committee assures to stay the course into the next financial year.
After a six-month wait, the Reserve Bank of India’s monetary policy committee finally cleared the picture on growth and inflation. Foreseeing a 9.5% contraction in real GDP in 2020-21, the MPC has completely shifted its focus to the massive negative output gap caused by the Covid-19 pandemic. This it does with assurance to stay the present course for the next three quarters, in the last of which (April-June 2021) it sees inflation declining close to the target, or 4.3%. This bold guarantee, or commitment to see through the currently above-target inflation, which is understood to be driven essentially by supply factors, is the crux of the October monetary policy review.
The large bouquet of the other developmental and regulatory measures announced are, at best, marginal changes to existing ones with the only new element being the specific, time-bound open market operations for state development loans.
Within this broad-brush interpretation of monetary policy review, the two questions of significance are the following: Is this signal-turn or monetary stance appropriate? And two, what does it signify?
A Bold Commitment
The decision to continue the accommodative stance for growth support during the period is entirely justified. It is correct in the light of the enormous output gap uncovered initially, by the national statistical agency for the first quarter in which growth contracted by a quarter percent. Now, the RBI projects real GDP to contract 9.8% in the just-ended September quarter, 5.6% in the current quarter, and turning marginally positive at 0.5% in January-March 2020-21. Risks to this growth outlook are bent to the downside.
Arguably, the RBI is very sure and has complete clarity about the deeply-depressed aggregate demand conditions, upon which is founded the unprecedented decision to continue with the presently set stance and look-through inflation that has persisted above the tolerance zone for several, consecutive months.
Next, what does this signify? Compared to its growth reading, the RBI appears less sure or certain about inflation. The risks here are evenly balanced with the confidence bands in the inflation fan chart showing large uncertainty on either side. The key point about the inflation understanding is this is purely supply-driven. The cost-push pressures are sourced to Covid-19-related disruptions that include labour shortages and high transportation costs; pricing power remains weak on subdued demand.
The central bank anticipates these supply-side pressures upon prices will ease progressively with unlocking and reopening of the economy, helped further by softer trends in global crude oil prices. Based on these assumptions, headline CPI inflation is projected to decline into the 5.4-4.5% region in this year’s second half, further fall to 4.3% in the first quarter of the next fiscal year.
Supply-Side Fixes: Government’s Domain
The second point here is that the onus of adherence to the projected inflation path is squarely upon the government. In the detailed monetary policy report that accompanied the MPC statement, the central bank flags “...the inflation outlook will also depend upon trade policies and effective supply management measures with respect to key inflation sensitive items”; while the current projections incorporate firmness of some prices (pulses, oilseeds) from elevated import duties.
So the takeaway position is this: on its part, the MPC has assured to stay the present monetary course if inflation pans out according to the projected path but it is for the government to ensure this is achieved!
So it is the government that will have to ensure that supply shocks dissipate. That is, it has to see that the pandemic-related supply disruptions ease for smooth passage and deliveries of goods, besides effective management of various food supplies as well as changes to trade policies.
Guidance On The Next Move
The final point to consider against the RBI’s assurance is that if the policy rate could be cut further if inflation evolves as projected? A careful reading of the monetary policy statement suggests there’s no ambiguity that the answer to this question is yes. The central bank clearly says in para 8 of statement that the MPC decided to maintain the status quo on the policy rate—obviously based upon the projected inflation and growth paths until April-June 2021—and will await the easing of inflationary pressures to use the space available for supporting growth further.
If the uncertainty on inflation lifts in the coming months, which will happen when supply shocks taper off as visualised in the fan chart, and the RBI is surer of reaching the 4.3% CPI inflation forecast in April-June 2021, it will ease the policy rate some more. In other words, the central bank will cut the policy rate only if there is no upside surprise to inflation. By how much is something that will become clearer ahead and hard to predict at this juncture.
On this, the RBI joins hands with the central banks of advanced countries, such as the U.S. Federal Reserve that recently decided to look at average inflation. However, unlike these central banks that are grappling with its absence, the RBI is facing the constraint of above-target inflation. Nonetheless, its MPC has chosen to take this fair risk based on current projections.
Bond and currency markets may have cheered the on-tap TLTROs, the extension of enhanced held-to-maturity limits to March 31, 2022, revised and rationalised risk weights for retail and housing loan portfolios, amongst other such measures in yesterday’s review. But it is this first-ever and bold move of the MPC to stay accommodative, a forward guidance for at least three quarters ahead, which materially alters the economic environment. That is the fundamental change. It is over to the government next.
Renu Kohli is a New Delhi-based macroeconomist.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.