Maintaining the balance

MPC has enhanced the scope of policy debate

The first meeting of the reconstituted monetary policy committee (MPC) raised several important issues and enhanced the scope of policy debate. Economic conditions in India are perhaps more complicated at this stage than in other large economies. Inflation is running above the central bank’s tolerance band for several months and could remain elevated in the near term even as the economy is expected to contract by about 10 per cent in the current fiscal year. High inflation is not allowing the rate-setting committee to reduce interest rates further to support economic activity. It is in this context that the views of the MPC members become more critical.

Interestingly, as the minutes of the meeting released last week showed, newly app­ointed member Jayanth Varma expressed disagreement with the language of the policy resolution. He argued that the MPC could damage its credibility if it used words which did not reflect what it meant. It should be able to respond aggre­­ssively in the case of inflation shock. He further noted that formal guidance for six months in the policy resolution was suboptimal. A credible policy would comp­ress the inflation risk premium and reduce the steepness of the yield curve. Hig­her longer-term rates not only affect investment in the economy, they also attract foreign funds in the debt market and push up the real effective exchange rate.

While the arguments made by Dr Varma need attention and should be debated, it is worth noting that longer-term yields are also affected by the quality of the fiscal policy. India runs one of the largest budget deficits among its peers, which is likely to increase significantly this year. Internal committee member Mridul Saggar touched upon this issue and underscored that the slope of the yield curve is not really a predictor of the expected inflation and growth because of higher government borrowing. Both — the financial markets and the central bank — need to factor in the possible consequences of fiscal expansion over the medium term. However, the immediate concern for the rate-setting committee is the nature and course of inflation. The MPC sees the current spike in inflation as transient and expects the rate to moderate as supply improves because of the opening up of the economy. The Reserve Bank of India (RBI) expects inflation to come down to 4.3 per cent in the first quarter of the next fiscal year.

However, there could be risks to the projected path. For instance, RBI Deputy Governor Michael Patra in his remarks noted that supply shocks from fuel and food prices accounted for 71 per cent of the inflation deviation in the first half of the current fiscal year. This was followed by unanchored inflation expectations. While the overall supply is easing, food prices, particularly rising vegetable prices, could be a worrying point. Further, the massive infusion of liquidity into the system and policy focus on supporting growth, which is not unjustified, could affect inflation expectations in the near to medium term. Thus, depending on how the inflation condition evolves in the coming months, the central bank would need to effectively communicate its policy position. Given the inflation outlook, a policy rate cut is unlikely in the near term. An extended decline in real interest rates could create significant distortions in the economy with longer-term implications.