There has been considerable public interest looking forward to the forthcoming meeting of the RBI’s Monetary Policy Committee (MPC) scheduled for December 5-7.
The RBI may decide to continue its withdrawal of monetary policy accommodation by further raising the repo rate under the Liquidity Adjustment Facility (LAF). Or, it will pause the repo rate hike. But it is time to pause.
Since January, the annualised CPI inflation has been above 6 per cent, far above the RBI’s targeted 4 per cent.
Responding to this, the RBI has raised repo rate under LAF on four consecutive occasions since May, totalling 1.9 percentage points. The repo rate is 5.9 per cent now up from 4 per cent before May 4.
Despite this monetary tightening, the CPI inflation in October came in at a high 6.8 per cent. Will the RBI continue raising repo rate?
It is pertinent to note that the present situation is a bit tricky. The economy, which appeared to have recovered after the pandemic, has shown some signs of decelerating recently. The causes may be partly external arising from the Russian-Ukraine war, and the consequent rise in oil prices.
So, in the context of rising inflation and slowing growth taking a call on further rate hike becomes challenging.
Supply vs demand shocks
Prices can rise either due to a positive demand shock (such as rise in household consumption expenditure, investment, government expenditure, and exports over imports) or due to a negative supply shock (such as bad monsoon, international oil price hike, and Covid like pandemic) or combination of the two.
It is widely believed that if a price rise is associated with economic slowdown, then negative supply shocks are the dominating factor.
In contrast, rising prices along with high growth occur mainly due to positive demand shocks.
Monetary tightening is most appropriate when the inflation is caused by a positive demand shock as it reduces aggregate demand, and helps in reducing inflation, if it is caused by a positive demand shock.
However, if the inflation is caused due to a negative supply shock, monetary tightening will moderate inflation, but growth tends to suffer.
The average inflation for 2022-23 (April-October) at 7.1 per cent, is higher than the 5.5 per cent print of 2021-22. The growth in 2022-23 is projected at 7 per cent, lower than the 8.7 per cent posted in 2021-22. These numbers point to negative supply shocks causing the current inflation.
Policy dilemma
So can we afford further loss of economic growth by monetary tightening?
The ‘inflation targeting’ framework followed by the RBI and central banks world over has led to this policy conundrum.
The central banks need to clearly assess the impact of their monetary policy action both on prices and growth with precision.
Accordance of topmost priority for ‘price stability’ under inflation targeting has steered the central banks out of the conflicting objective of growth-price stability trade off.
Nevertheless, the adverse consequences of pursuing the mandated ‘inflation target’, particularly when the economy suffers from negative supply shocks, cannot be completely ignored.
If the central bank’s main objective is price stability, other government institutions need to do the heavy lifting for ensuring growth.
But under a tight money policy, can other institutions be successful in boosting growth?
It makes sense to wait and watch, if the cumulative hike of repo rate by nearly 2 percentage points over the last seven months is sufficient to glide inflation back to the RBI’s comfort zone. It is time to pause.
The writer is Professor, Department of Economics, Pondicherry University, Puducherry.