Turn and bounce

MPC needs to be extremely vigilant

Central banks around the world have been on a sticky wicket, especially since the commencement of the recovery from the disruption caused by the pandemic. The inflation rate surged in most advanced economies to levels not seen in decades. After the initial misreading and reluctance, systemically important central banks acted decisively. The Reserve Bank of India (RBI) increased the policy repo rate by 250 basis points since May 2022 to contain inflationary pressures before pausing. The pause was extended last week after the bi-monthly Monetary Policy Committee (MPC) meeting. Although the outcome of the meeting was expected, the RBI did well to highlight risks. RBI Governor Shaktikanta Das in his statement, for instance, noted that the pressure from food price inflation might not see a sustained easing. The monsoon has been uneven and the inflation trajectory, to an extent, will be shaped by El Niño conditions. Global food and energy prices have also been volatile.

The governor also emphasised the need to manage liquidity in sync with the monetary policy stance. However, the announcement of open-market operations to manage liquidity when the operating target of the monetary policy — the weighted average call rate — is trending above the policy rate, surprised the market, and that pushed up the yields on benchmark 10-year government bonds by 12 basis points. Given the evolving liquidity conditions, Mr Das aptly noted that it was a turning pitch and the RBI would play its shots carefully. However, in terms of overall management of inflation, the pitch seems to have both turn and bounce. Along with the shift in drivers, inflation outcomes have regularly surprised on the upside. After witnessing a moderation in the first quarter this financial year, the inflation rate has again surged, largely because of food prices, to levels significantly above the upper end of the tolerance band. Notably, however, the MPC decided to retain its inflation projection for the financial year.

The RBI’s communication appropriately reiterated that its target was a 4 per cent inflation rate, not 2-6 per cent. But it may have to wait for a while to reach the target on a durable basis. In fact, it has already been a long wait. The average inflation rate since March 2020 has been above 6 per cent. The reading in most months has been above 5 per cent. Thus, it remains to be seen when the RBI achieves the target on a durable basis. The policy choices have become more complex because the headline rate is now being driven by supply-side issues, while the core rate has softened. The Monetary Policy Report — also released last week — showed that the RBI had retained its baseline assumption for crude oil at $85 per barrel. Although prices have corrected in recent days, most forecasts suggest it will remain elevated. According to the RBI’s calculation, a 10 per cent increase in crude oil prices above the baseline could push up the inflation rate by 30 basis points.

Besides the monetary policy complications, as underlined by Mr Das, higher growth in personal loans deserves attention. It is worth determining if the increase is a result of greater penetration of formal credit facilitated by new-age fintechs or if households are borrowing for other reasons, even at a time of higher interest rates, which could increase stress in the banking system.