Don't take foot off pedal

RBI should note that inflation still menaces the economy

The six members of the Reserve Bank of India’s (RBI’s) Monetary Policy Committee (MPC), led by Governor Shaktikanta Das, are due to hold their next meeting from Monday to Wednesday this week. The MPC, which sets the benchmark interest rates, has hiked rates by 190 basis points since the middle of this year. In May, the MPC had hiked rates by 40 basis points; and, since then, each of the three times it has met it has raised rates a further 50 basis points. The MPC has been forced towards these sharp increases, given the fact that consumer price inflation was consistently outside its target zone. In September, inflation hit a five-month high of 7.4 per cent. In October, however, inflation was recorded at 6.77 per cent. This remains well above the RBI’s “tolerance band” for inflation, which extends for two percentage points above and below the 4 per cent target. Yet the decrease, and expectations that there will be a further decrease visible in November’s data, has led to many calls for the MPC to moderate its stance in order to protect a growth recovery.

However, the MPC should ignore these calls and stay focused on its primary mandate of controlling inflation. It cannot afford to be overoptimistic about the inflation trajectory in India. The current projections for that trajectory from the central bank are that it will dip below the upper end of the tolerance band to 5.8 per cent in the fourth quarter of the current fiscal year from 6.5 per cent in the third quarter. It will then move further downwards towards 5 per cent in the first quarter of 2023-24. However, these projections cannot be used to soften the RBI’s stance for multiple reasons. First, the central bank’s record of inflation prediction is generally poor. If that had not been the case, inflation would not have been outside the tolerance zone for so many successive months, leading to the MPC being forced to draft an explanatory note to the government as laid out in its legal mandate. Second, while commodity prices — a major driver of inflation in India — may appear to be on a downward trend globally, the MPC must still focus on the possibility, clearly visible in the disaggregated data, that expectations of higher prices have become more generalised. These expectations must be rooted out. Third, the path of global commodity prices themselves remains sharply uncertain because much depends on developments in the Russia-Ukraine war as well as on the complicated fallout of attempts to control or cap Russian revenue from its energy exports. Nor is China’s reopening from its Covid Zero strategy easily predictable, which would greatly affect demand and thus commodity prices. Fourth, the fact is that Indian interest rates — like those of many other emerging economies — must be set keeping in mind the need for stability on the external account. India’s sustained trade deficit means it cannot afford the capital flight that would be the consequence of too great a risk-adjusted interest differential between India and the advanced economies.
 

There is no doubt that the Indian economy’s nascent recovery needs to be protected. But a tough inflation-fighting stance from the central bank will not do as much long-term harm to India’s growth prospects as would allowing this long run of inflation above the tolerance zone to continue.