In the monetary policy resolution announced on August 6, 2021, the Monetary Policy Committee (MPC) decided to keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 4 per cent, and consequently, the reverse repo rate and the marginal standing facility (MSF) rate were also kept unchanged.

It also decided to continue with the accommodative monetary policy stance till the economy recovers from the shock of the Covid-19 pandemic and the CPI inflation rate is contained within the mandated 2-6 per cent band.

However, the minutes of the MPC meeting indicated that there was some divergence of opinion among the MPC members regarding this resolution. The dissenting view argued against the accommodative stance of the MPC as the projected inflation is beyond the target inflation rate set.

The presence of such a dissenting view has generated quite a bit of interest in the media.

While a plurality of views within the MPC could make the monetary policy decision-making process more mature, in this case, commentators started speculating whether the RBI has deviated from its mandate of flexible inflation targeting (FIT) and started emphasising growth (or its lack) over inflation.

Admittedly, the task of the central bank is to routinely do this tightrope walk, balancing growth and inflation. Depending upon whether inflation is triggered by demand-pull or cost-push factors, an appropriate decision is arrived at. A related important take is who the Enemy Number 1 at the current juncture is: lack of growth or the presence of inflation (triggered by demand-pull factors and associated abundance of liquidity or heightened inflationary expectations)?

There are reasons to believe that the inflation faced by India currently is more of a supply-side problem. Due to long and uneven lockdown, the supply chains of the country have got negatively affected. At the same time, due to several reasons, international commodity prices are going up.

This is seen in high prices of fuels, including crude oil and coal, metals like copper, aluminium and steel, cotton and other industrial inputs. Global container and semiconductor shortages are also adding to the woes.

Product prices

The combination of all these factors has perhaps forced many Indian industries to raise the prices of their products. The projected inflation by the MPC also takes into account the rise in food prices in India. It highlights that price of edible oils, pulses, eggs, milk and vegetables are going up. An uneven and deficient monsoon may also add to this price pressure of food products. All these factors may lead to higher inflation in the coming months.

However, the nature of this inflation is very different from the demand-side led inflation discussed above. When inflation originates from the supply side, it will be very difficult to contain it by pushing up the rate of interest. In fact, if the interest rate is raised, then there can be additional cost pressure on the firms as the cost of borrowing goes up. This may lead to further price increases.

Is it possible that the current Indian inflation is a combination of both cost-push and demand-pull inflation? The MPC statement has an answer to this. It shows that though the industrial production has shown a remarkable rate of growth on a year-on-year basis, “but it was still 13.9 per cent below its May 2019 level”.

The RBI OBICUS survey of the manufacturing sector also indicates that the aggregate capacity utilisation is still below 70 per cent in Q4:2020-21.

The latest quarterly GDP statistics released on August 31 show that though there is a significant quarter-on-quarter nominal growth rate, that is largely because of the base effect. It also shows that in real terms, many industrial and services sub-sectors have not yet reached the pre-Covid production levels.

Therefore, in spite of the spurt in the nominal growth rate, it is unlikely that there is a demand pressure on the economy, which needs to be suppressed using higher interest rates.

Covid effect

Also, it must be kept in mind that there is a lot of uncertainty about Covid and its variants. There are speculations about the possibility of a third wave, and sporadic outbreaks of the disease are still happening in different parts of the world.

Given the volatility and uncertainty still associated with the pandemic, significant downside risks persist. In such a situation, projections based on past data with the assumption of business-as-usual can go wrong. Because of all these uncertainties, it seems pretty rational for the MPC to support the incipient recovery and be dovish on the projected inflation.

There was also a suggestion in the MPC committee that the reverse-repo rate should be increased. The reverse-repo rate allows the banks to park their additional funds with the RBI and earn interest rates. In a regime where the government is using the credit channel to fuel the economic recovery, such a policy step can be seen as promoting ‘lazy banking’.

This would have particularly sent a wrong signal when the brunt of the economic recovery in India is being borne by the monetary policy. Unlike some of the developed countries, the size of the fiscal policy measures has been relatively modest in this country. With such a burden, it is perfectly sensible if the RBI chooses to err on the side of caution and focus more on sustaining the nascent but uncertain growth process.

With so many uncertainties around, it is indeed wise for the Atlas not to shrug.

Pal is Professor of Economics in IIM Calcutta, and Ray is Director, National Institute of Bank Management, Pune.