Don't depend on MPC alone

Maintain balance between growth and financial stability

The first advance estimates of gross domestic product for the current year, released by the government on Tuesday, showed that growth in the Indian economy will slow to 5 per cent, compared to 6.8 per cent last year. Since most high-frequency indicators suggest that a sharp rebound is unlikely in the near-term, stakeholders are looking for policy support. While it will take a few weeks to know to what extent the government is willing to support growth through the Budget, markets have been hoping that after a pause in December, the Reserve Bank of India (RBI) will lower policy interest rates to push up economic activity when the Monetary Policy Committee (MPC) meets next. Such expectations, however, were dented by the remarks made by RBI Governor Shaktikanta Das on Tuesday. Mr Das rightly said that persistently high inflation affects the economy’s allocative efficiency and obstructs growth. He also reasoned that high inflation worsens income distribution by lowering the real income of the poor.  

The MPC’s surprise move in December was partly because of higher consumer price inflation, which touched a 40-month high of 5.54 per cent in November. Economists predict that it will now cross the 6 per cent mark — the upper end of the target band. Currently, retail inflation is largely being driven by food prices, as core inflation is at a lower level, reflecting lower pricing power and weak demand in the economy. So, should the rate-setting committee look through the factors driving inflation and reduce rates to support growth in its next meeting? It is important to note that the mandate of the RBI is to target headline inflation.
 

As the outcome of the December meeting showed, it will not be easy for the MPC to cut rates. Minutes of the meeting showed that the committee was not worried about vegetable prices alone, and as Mr Das noted: “…there is a need for greater clarity as to how the overall food inflation path is going to evolve, as there is some uncertainty about the outlook of prices of certain non-vegetable food items such as cereals, pulses, milk and sugar.” He also highlighted the lack of clarity on how the telecom tariff hike will play out. Further, the upcoming Budget will play a big role in the next monetary policy decision. A large fiscal slippage will naturally deter the MPC from cutting policy rates. A surge in crude oil prices, owing to tension in West Asia, will also increase risks to the inflation outlook.

There is no doubt that the Indian economy needs support, but it is worth debating whether it makes sense to risk financial stability to support growth in the short run. Will it pay to have an excessively accommodative fiscal and monetary policies, along with an abundance of liquidity in the system? Further, what are the chances that the policy impetus will quickly revive economic activity and India will be able to withdraw the stimulus before an external shock hits the economy? It would be advisable to maintain a fine balance between supporting growth and preserving financial stability. The policy target should be to attain a durable recovery in economic growth, which may not come with another rate cut alone.