RBI monetary policy: Pursuing growth in times of high inflation

Unlike the first wave, elevated inflationary pressures and record low policy rates have left the RBI with very few policy levers to support growth amid the second wave.
 
Yet, the RBI and the MPC have deftly manoeuvred through these constr­aints to support growth by relying on measures outside the conventional monetary policy toolkit. With no space on policy rates, the RBI has endeavoured to support growth through additional government bond purchases under GSAP 2.0 to prevent financial conditions from tightening prematurely. The decision to buy state development loans is a good step given the higher expenditure burden on states from rising healthcare expenses.  Targeted policy responses such as the on-tap liquidity window for contact-intensive sectors and enabling a larger set of borrowers to benefit from the Resolution Framework 2.0 is exactly the response essential for survival of the worst-affected segments during the pandemic crisis.

 
And finally, by retaining the state-based forward guidance, the MPC has maintained adequate flexibility amid large uncertainties (inflation and global spillovers), while the commitment to stay accommodative ‘to revive and sustain growth on a durable basis’ gives a clear signal on growth support.  
 

In the post policy press conference, the RBI officials stated the MPC believes that inflation is ‘not persistent’ and that there is ‘no thinking’ about policy normalisation.
 
It is not clear to us whether inflation will not be persistent. It is true that inflation is supply-side driven right now due to higher commodity prices and supply-chain bottlenecks, but faster build-up of rural wages due to a lower labour force participation rate and rising household inflation expectations are already a tell-tale sign. With the economy likely to gradually improve alongside faster vaccinations in the coming months and the risk of higher services price inflation from the re-opening, upside risks to inflation from both the goods and services sectors are rising. Even without demand-pull inflation, underlying inflation appears to be stabilising around 5 per cent.

 
We also see a risk that the RBI may be overestimating the growth damage from the second wave. Its downgrade of Q1 FY22 GDP growth to 18.5 per cent YoY (from 26.2 per cent earlier) appears too steep to us. We estimate that the RBI now expects a GDP contraction of over -12 per cent quarter-on-quarter, on a seasonally adjusted basis, roughly half of the first wave impact. We believe this is too pessimistic. International evidence shows that countries have seen a much smaller growth drag from their second and third waves, due to more nuanced lockdowns, adaptation to the new normal and stronger global growth. Hence, we believe there will be a positive surprise when Q1 GDP data are released at end-August. Moreover, the faster pace of vaccinations over the coming months suggests that current downbeat consumer sentiment and risk aversion among lenders and borrowers should both brighten as the pandemic uncertainty subsides, supporting faster growth.

 
For now, with the pandemic uncertainty still reigning, we believe that the MPC will likely stay on hold for the foreseeable future by assigning a higher weight to growth over inflation. However, as domestic growth recovers in the coming months, pandemic uncertainty ebbs and inflationary pressures remain elevated, the weight assigned to inflation should rise.
 
The Fed’s mantra of patience is the right strategy to adopt, but only for the near term.
 
The writer is the chief economist for India and Asia, ex-Japan, at Nomura