Inflation risks

Most economists do not expect the Monetary Policy Committee (MPC) to change either the policy rate or the stance on Friday, but will keenly watch the commentary accompanying the decision. The inflation rate, based on the consumer price index, has been running above the tolerance band of the Reserve Bank of India (RBI). The stated position of the central bank — like some of its peers in advanced economies — is that higher inflation is transitory. It has noted that supply-side disruptions, owing to the pandemic-related restrictions, higher margins and taxes are driving inflation. The.....
Most economists do not expect the Monetary Policy Committee (MPC) to change either the policy rate or the stance on Friday, but will keenly watch the commentary accompanying the decision. The inflation rate, based on the consumer price index, has been running above the tolerance band of the Reserve Bank of India (RBI). The stated position of the central bank — like some of its peers in advanced economies — is that higher inflation is transitory. It has noted that supply-side disruptions, owing to the pandemic-related restrictions, higher margins and taxes are driving inflation. The central bank is focused on supporting economic recovery. Although the second wave of Covid-19 had a limited impact on economic activity, it weakened the recovery process considerably.

In the given economic setting, the RBI intends to keep market interest rates at a comparatively low level to help businesses borrow at lower costs. To keep market interest rates low, the central bank has infused a large amount of liquidity into the system — both through conventional and unconventional means. Higher liquidity and lower rates are also allowing the government to borrow at lower interest rates. The rationale for policy accommodation is well understood and, to its credit, the RBI did most of the heavy lifting in the initial phase of the pandemic. But some market participants are puzzled by the extent to which the central bank is willing to tolerate inflation risks. To be sure, the condition in India is significantly different from the one in advanced economies, which have seen lower levels of inflation for a significantly long period, and expectations are well anchored. Yet the recent spike in inflation, particularly in the US, is being debated and officials at the Federal Reserve are adjusting to incoming data. India has a history of relatively higher inflation —  the average rate, for instance, was above the tolerance band last year.

 
Therefore, the RBI should explain how it sees the recent spike in inflation, which is expected to remain elevated for some time. Consequently, the MPC needs to revise its full-year inflation projection from 5.1 per cent — pushing it further away from the target of 4 per cent. The MPC should also debate if excess liquidity in the system is affecting inflation outcomes. Besides, lower interest rates have not resulted in higher credit growth. Thus, the potential risk of maintaining a significantly high level of liquidity could be higher than the perceived benefits. Consistently ignoring inflation risks could affect expectations and increase longer-term macroeconomic costs. Thus, a clear communication from the RBI will be critical at this juncture.

Since an abrupt change in policy can have an undesired and disproportionate impact, financial markets will expect the RBI to give a near-term road map for policy normalisation. The RBI did allow the yield on 10-year government bonds to go above 6 per cent last week, which could be a step towards normalisation. The next move should be to systematically reduce the amount of liquidity in the system and allow the call rates to come within the monetary policy corridor before normalising the corridor itself. Allowing short-term rates to drift below the reverse repo rate is also undermining the MPC. It remains to be seen if the rate-setting committee will shift its focus this time.


Dear Reader,


Business Standard has always strived hard to provide up-to-date information and commentary on developments that are of interest to you and have wider political and economic implications for the country and the world. Your encouragement and constant feedback on how to improve our offering have only made our resolve and commitment to these ideals stronger. Even during these difficult times arising out of Covid-19, we continue to remain committed to keeping you informed and updated with credible news, authoritative views and incisive commentary on topical issues of relevance.

We, however, have a request.

As we battle the economic impact of the pandemic, we need your support even more, so that we can continue to offer you more quality content. Our subscription model has seen an encouraging response from many of you, who have subscribed to our online content. More subscription to our online content can only help us achieve the goals of offering you even better and more relevant content. We believe in free, fair and credible journalism. Your support through more subscriptions can help us practise the journalism to which we are committed.

Support quality journalism and subscribe to Business Standard.

Digital Editor

Business Standard is now on Telegram.
For insightful reports and views on business, markets, politics and other issues, subscribe to our official Telegram channel
Key stories on business-standard.com are available to premium subscribers only.

Already a premium subscriber?

Subscribe to get an across device (Website, Mobile Web, Iphone, Ipad, and Android Phone applications) access to Premium content, Breaking News alerts, Industry Newsletters, Stock and Corporate news alerts, access to Archives and a lot more.

Read More on

MONETARY POLICY COMMITTEE

INFLATION

INDIAN ECONOMY

RBI MONETARY POLICY

BUSINESS STANDARD EDITORIAL COMMENT

RBI

OPINION

EDITORIALS


Most Read

Markets

Companies

Opinion

Latest News

Todays Paper

News you can use