Why RBI’s No-Surprise Monetary Policy Review Was The Best Course

Under Omicron’s shadow and inflation developments, a hold was expected.

The arrival of the Omicron Covid-19 variant had removed any doubts about monetary policy changes at the Dec. 8 review. Even otherwise, the likelihood of a pause was indicated by inflation developments, though several analysts and market participants expected a reverse repo rate hike. The rise in October retail inflation was slight (4.48% against 4.35% in September) with vegetable prices the principal driver, neutralisation from reductions in fuel levies was still to reflect in headline and core prices’ growth, and global crude oil prices softened. Chances of monetary action in this light—and without growth taking a firm foothold—were minimal, notwithstanding increased inflation anxieties abroad including the U.S. Federal Reserve chairman’s shift to drop the ‘transitory’ description of U.S. inflation and implied tightening of financial conditions from a faster withdrawal of bond purchases.

Growth, Inflation Outlook

With these in the backdrop, the monetary policy committee could afford to wait and it unanimously chose to keep the repo and reverse repo rates unchanged. Further, and as at the previous review, it voted 5-1 to continue with the ‘accommodative stance as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of Covid-19 on the economy, while ensuring that inflation remains within the target going forward’. The annual projections of inflation and growth remain intact—a respective 5.3% and 9.5%—with quarterly redistributions. Specifically, the present quarter’s retail inflation is now projected at 5.1% against 4.5% before; it lifts up to 5.7% next quarter versus 5.8% forecast in October. Inflation is predicted to moderate to 5% in the first two quarters each next year (5.2% for Q1:2022-23 earlier). Real GDP is now projected to grow more slowly in the last two quarters of this year - 6.6% and 6% respectively compared to 6.8% and 6.1% before. Next year, growth steadily recovers to 17.2% in the first quarter followed by 7.8% in July-September 2022 (upon 8.4% estimated by CSO on November 30).

Why The Benign View On Inflation

As can be seen, the inflation outlook is more benign than commonly perceived, for example, a comparable and respective 5.3% and 6% in this and next quarter of FY22 by most participants. The RBI expressed concerns about core inflation that is sticky above 5% for long; however, this link to generalised inflation is expected to soften by the recent reductions in fuel levies and duties on specific items. Deputy Governor Michael Patra elaborated at the post-policy interaction that inflation is expected to trend close to target by the end of FY23 when it is seen in the 4-4.3% region.

Several reasons impart assurance to the central bank.

1. It is helped by the measures and latitude with the government – be it oil, other imports, or food prices, the extent and layers of excise duties, tariffs, and other such are many and can be deployed to check inflation, especially its core elements.

2. The central bank has the tools and space to manage depreciation triggers, should these arise in the course of taper adjustments, financial and asset price volatilities that are the chief expected risks ahead.

3. Core inflation is equally limited on the demand side by the degree of economic slack – there’s no evidence so far to support concerns of a wage-price spiral formation from rising prices and tightening labour market.

4. Credit demand is extremely weak—its annual pace has increased a bare 10-20 basis points each month, is under-3% in real terms, while loaned deposits of banks are 5 percentage points below February 2020 levels—while monetary aggregates show no sign of lighting up.

5. The inflation dynamics linked to public debt and deficits remain subdued until now, possibly because of the depth of depression in demand.

Risks To That Inflation Outlook

There are some features worth flagging in the above context. The first is the Rs 3.74 lakh crore additional spending announced by the government recently; adjusted for savings and/or higher receipts elsewhere, the net expenditure stated by the government is almost Rs 3 lakh crore above the budgeted amount. There’s no clarification about its financing, whether market borrowing—the monetary policy statement does not mention this—or the National Small Saving Fund from which Rs 17,000 crore have been taken to October according to monthly accounts of the central government.

Higher nominal GDP growth (14.8% against 14.4% upon FY21 nominal GDP that stands revised up to Rs 197.45 lakh crore compared to the initial Rs 194.81 lakh crore estimate) gives extra space that may keep the deficit bounded at the budgeted 6.8% of GDP. However, growing NSSF liabilities add to the stock of public debt, which at 90.7% of GDP (as per the IMF) last year, raises a potential threat that could materialise with demand return.

Two, the elevated inflation expectations of households on which the MPC said nothing while pointing to improving business outlook and consumer confidence from its surveys. Given the long period in which the MPC has passed over temporary inflation spurts—to accommodate easy monetary policy required by the adverse demand shock—could provide the opportunity for inflation expectations to settle in; there’s a risk of losing the short-term space with their de-anchoring.

The third is the relationship of recovering demand with the state-contingent accommodative stance and the size of the output gap. When asked what the metric for durable recovery may be, the RBI governor pointed to its unevenness – equal to or above pre-pandemic in some aspects, lagging in others. This is a source of uncertainty, especially as interpreting demand and its connection with inflation due to unusual disturbances caused by the pandemic is very difficult. To a specific query on the output gap, Deputy Governor Patra answered it was very, very large and would take several years to recover. The short- and medium-term ambiguities about the degree of economic slack are thus significant. The depth of economic damage, including that to potential output—before covid and due to it—lacks measurement clarity. These increase the risk of timing policy adjustments in lockstep.

At this point, with Omicron threats unclear and uncertainty in either direction until more is known, the overall configurations merited watchfulness but not action. This was the best course.

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.