Increasing policy challenges

RBI should not digress from maintaining price stability

Inflationary pressures are rising once again. The inflation rate based on the consumer price index went up to 5.03 per cent in February, against 4.06 per cent in the previous month. The wholesale price index-based inflation rate increased to a 27-month high of 4.17 per cent. While the headline numbers may not look particularly worrying at this point, the underlying conditions could make policy choices more difficult for the Reserve Bank of India (RBI). Core inflation remained elevated and increased to about 6 per cent in February — the highest since November 2018. It is now being driven by transportation costs on the back of higher fuel prices, among other things. Also, a rapid increase in new Covid cases and various restrictions in different parts of the country can again disrupt supply chains and push up prices.

Fuel prices are likely to remain elevated in the foreseeable future. Despite the recent correction, global crude oil prices are up over 20 per cent since the beginning of 2021 and may remain at higher levels because of supply-side issues. In fact, the increase in commodity prices is more broad-based. The Economist commodity-price index, for instance, has gone up by over 50 per cent over the level last year. To be sure, the price increase looks high, partly because of a lower base but prices may also be rising because of supply disruptions across the world over the last 12 months and higher anticipated demand. A sharp rebound in demand, particularly in the US, could further push up commodity prices. The latest fiscal stimulus in the US, worth $1.9 trillion, is expected to boost demand and prices, which is also being reflected in the bond market.

The economic backdrop clearly suggests that policy management will remain challenging. The RBI is not only expected to nurture the ongoing economic recovery but also manage a significantly large government borrowing programme in a non-disruptive manner. Higher government borrowing is affecting the cost of money. Yields on 10-year government bonds, for instance, have increased by about 30 basis points since the presentation of the Union Budget. Bond prices would remain under pressure because the availability of both external and domestic savings is expected to decline. Higher yields in global markets would affect portfolio capital flows, and revival in demand has reduced financial savings in the domestic market. Thus, a higher supply of government bonds would increase market rates.

However, excessively accommodative monetary and liquidity conditions to contain rates could end up fuelling inflation. The review of the inflation target is also due this month. RBI research shows that the current target of 4 per cent with a tolerance band of 2 percentage points on either side has worked well. The government will be well advised to maintain the status quo on this front. Also, the RBI should explain how it intends to deal with higher core inflation. The present situation requires greater coordination between the RBI and the government. The central bank will need to convey to the government that it should be willing to pay a higher price for increased borrowings. Expecting the bond market to not react to fundamental changes will not help. The RBI itself should not be seen as deviating from the objective of maintaining price stability to manage yields for the government.