Close the policy gap

RBI has fallen behind the curve

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) will meet this week for the first time in the new fiscal year and would be expected to set the tone for FY23. The broad macroeconomic conditions — partly because of the Russian invasion of Ukraine — have changed significantly since the committee reviewed the policy in February. Global commodity prices have gone up, and now the state-owned oil-marketing companies have started passing on the increase in crude oil prices to retail consumers after a long pause, which is likely to push up the inflation rate further. The inflation rate based on the consumer price index (CPI) is already above the tolerance band of the RBI. The challenge for the rate-setting committee, thus, will be to guide the policy in an environment where the inflation rate is likely to be significantly higher than previous estimates, while growth is expected to be lower.

A recent poll of economists by this newspaper suggests that markets do not expect the RBI to do much in this policy. This is somewhat puzzling because in a similar poll in February, most economists expected the RBI to increase the reverse repo rate. The outlook on inflation has worsened since, and the RBI has far stronger reasons to act now than in February. For instance, even if the war in Ukraine stops, it is unlikely that Western countries would remove sanctions anytime soon. Higher commodity prices are also affecting India’s external balance. The merchandise trade deficit in FY22 was at a record high despite impressive growth in exports. A higher current account deficit, along with capital outflows, will put pressure on the rupee, which would further push up imported inflation. Prices are rising rapidly across the world and large central banks, including the US Federal Reserve, are adjusting to the new reality to contain inflation and preserve confidence in monetary policy.

The overall economic outlook, to be sure, is not favourable and the fact that economic recovery is still not strong enough will only increase difficulties for the central bank. The RBI has been prioritising economic recovery since the outbreak of the pandemic, but it needs to reassess how long it can follow this path. The beginning of the fiscal year provides a good opportunity to re-evaluate changing macroeconomic conditions and basic policy assumptions. If economic recovery is still not strong enough, would monetary policy accommodation help without creating macroeconomic risks? The RBI would do well to adjust its approach and take appropriate steps.

In this context, the MPC should first change its stance to neutral. An accommodative stance at this stage has no relevance. In operational terms, financial conditions have tightened over the past few months. Further, the RBI should normalise the policy corridor by raising the reverse repo rate. It is unlikely to disrupt financial markets and will make market interest rates more stable. This will also signal that the central bank is moving forward on the policy normalisation path. Finally, the RBI must reiterate its commitment to the legislated target of attaining and maintaining 4 per cent CPI inflation over the medium term. It often appears that the RBI is comfortable with an inflation rate of around 6 per cent — the upper end of the tolerance band. This could undermine the credibility of the central bank.