The Indian economy looks to be in better shape now compared to the conditions that prevailed in the initial phase of the Covid pandemic. Inflation at 4.35 per cent (y-o-y) in September 2021 and growth at 9.5 per cent for 2020-21 (MPC projections) make for a comfortable picture. But pressures on the inflation front will soon come calling, emanating first from fuel inflation as crude oil prices have increased to $85 a barrel, which is significantly higher than the RBI assumption of $75 in the monetary policy report released earlier this month.
The report has also stated that assuming crude oil prices to be 10 per cent above the baseline, domestic inflation could be higher by 30 basis points (bps) and growth weaker by around 20 bps over the baseline. The Monetary Policy Committee (MPC) in its October 8 resolution admitted there will be pressures from input costs. In addition, commodity prices globally (both in advanced and emerging market economies) have remained at elevated levels, implying the pressures of imported inflation. Thus, inflation needs careful monitoring because of upside risks.
Under the Flexible Inflation Targeting, or FIT, framework, the target is the actual inflation while the intermediate target is the number thrown up by the inflation forecasting mechanism of the RBI done for the MPC. The two, forecast and the reality that follows, must be close for the forward guidance mechanism to be credible. By way of illustration, the MPC inflation forecast and actual inflation is set out in the Table.
The Table shows that the inflation forecast of MPC has broadly conformed to actual data, reflecting the credibility of the intermediate target. This is good. But at the same time, inflation has exceeded the upper tolerance level of 6 per cent in the first three quarters of 2021-22 and remained above the target of an average of 4 per cent during the whole of 2020-21 and H1 of 2021-22.
Further, the MPC forecast also states that the inflation will be above the average level during 2021-22 (5.3 per cent) and Q1 of 2022-23 (5.2 per cent). This raises legitimate questions on inflation management, particularly since the mandated targets have been exceeded on a sustained basis.
Nevertheless, we are in a post-pandemic phase of economic recovery. The objective of monetary policy as per the amended RBI Act is “to maintain price stability keeping in mind growth”. Thus, operationally, there is a dual mandate: controlling inflation and helping growth. In the current juncture, the priority remains to revive growth and move the economy to a higher growth trajectory.
Any move to tighten monetary policy by increasing the policy repo rate has the potential to adversely impact growth revival. This is because inflation management through rate increase will lead the economy to a “disinflation glide path” and higher interest rates, particularly at this juncture in the post-pandemic phase, will cause reduction in consumption and investment and in the end, growth will suffer.
Monetary tightening?
In the given circumstances, the question is: Should the MPC go for monetary tightening? This implies taking a pause in the accommodative monetary policy stance and increasing the policy repo rate.
It is important to note that the accommodative monetary policy stance has been continuing since February 2020 and the policy repo rate has been maintained at 4 per cent since May 2020. The accommodative stance broadly indicates a forward guidance that the policy repo rate will not increase. Repeatedly, the MPC has been reiterating that it would “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.”
There has been a debate in various fora as well as inside the MPC that continuation of accommodative monetary policy stance and keeping the policy repo rate at 4 per cent for a long time amidst the pressure of inflation does not augur well as the real interest rates have moved to negative zone. This will jeopardise savings and subsequently investment.
On the other hand, the MPC stance on accommodative monetary policy, with no change in the policy rate can help nurture recovery and move the economy to a higher growth trajectory that is durable and sustainable.
In the above context, the criticality of liquidity management of the RBI through conventional and unconventional monetary policy instruments needs further probing. It is important to mention that the unconventional monetary policy instruments in terms of Long-Term Repo Operation (LTRO), Targeted Long Term Repo Operation (TLTRO), Operation ‘Twist’ (the simultaneous purchase and sale of government securities in the outright open market operation) and G-SAP (Government Securities Acquisition Programme) have been introduced to inject high liquidity in support of the growth objective.
The surplus liquidity (daily average) was ₹9.5-lakh crore in October so far (up to October 6). The potential liquidity overhang amounts to more than ₹13-lakh crore (as seen in the RBI Governor’s statement of October 8.
Transmission mechanism
This improved liquidity coupled with the accommodative monetary policy stance has resulted in a favourable impact on the transmission mechanism of the monetary policy. The monetary policy report of October has observed that there has been a complete pass-through of policy rate reduction to weighted average lending rate (WALR) in terms of external benchmarking rate for fresh loans (policy rate reduction was 140 bps and WALR was reduced by 147 bps), and an encouraging trend in case of outstanding loans (WALR rate was reduced by 120 bps). In addition, credit offtake has also improved.
During H1, as the report has stated, credit offtake has improved, with non-food credit growth (y-o-y) increasing to 6.8 per cent on September 24, 2021, from 5.1 per cent a year ago.
There is a misconceived view that the authorities should focus more on fiscal support to revive growth rather than monetary easing. But given the absence of fiscal space, an increase in fiscal deficit to nurture growth will put pressure on financing the deficit from the market. The RBI, as a debt manager, will be compelled to manage the debt by injecting liquidity and, thus, adopting a path of monetary easing indirectly and non-transparently.
While the MPC is on the right track for an accommodative monetary policy stance, the Committee should as a forward guidance offer some time path for this rather than keep it open-ended. Saying that the stance will stay “for as long as long as necessary to revive and sustain growth on a durable basis” will not prepare the market to gear itself for prudent and effective management of liquidity as the growth revival picks up steam.
Keeping it open-ended pushes market to guess the RBI action. In policy, guessing is not the best way to move forward, and it will inevitably lead to the RBI getting into guessing the market behaviour.
The writer is a former central banker and a faculty member at SPJIMR. Views are personal. Through The Billion Press