Inflation warrior

The monetary policy committee (MPC) of the Reserve Bank of India (RBI) surprised financial markets with its unanimous decision to not cut the policy repo rate on Thursday. Although economic growth has slowed sharply in recent quarters, which raised the expectation of another rate cut, the rate-setting committee had strong reasons to pause. As argued by this newspaper before, the only reason in favour of another rate cut was that a status quo policy could possibly unnerve the financial market. The yield on the 10-year government bond went up by 14 basis points. 

It is true that the pace of economic expansion has slowed significantly over the last few quarters. Also, it can be argued that for a major economy, India appears far too worried about inflation targets, especially when other central banks are questioning their effectiveness. But the RBI has made its intention very clear: It wants to remain an inflation-warrior. The central bank has revised its inflation forecast upwards to 5.1-4.7 per cent for the second half of the current fiscal year. Although headline inflation is being largely driven by food prices and the central bank expects it to come down in the first half of the next financial year, it has taken a call to wait for more clarity. The sharp rise in household inflation expectations indicates the risk of ignoring inflationary pressures. Besides, food inflation is difficult to predict. One of the reasons why the central bank overestimated inflation in recent years was the difficulty in predicting food inflation. It would certainly want to avoid policy mistakes at a time when food prices are rising. Further, while RBI Governor Shaktikanta Das avoided questions on real interest rates in his post-policy media interaction, it is likely to have figured in the discussion of the MPC.

The MPC also rightly decided to wait for the Union Budget for more clarity on government policy. Again, though the central bank refrained from explicitly displaying its concern about the fiscal situation, the government’s revenue position is certainly worrying, and the central bank would need to do its bit to maintain an appropriate balance between the fiscal and monetary policies. A cut in the policy rate, anyway, would not have had the desired impact because most investors do not expect the government to stick to the stated fiscal deficit target.

Finally, while part of the bond market has reacted to the reduction in policy rates in the current cycle, transmission in bank lending rates has been fairly slow. The MPC’s decision to maintain the accommodative stance and ample liquidity in the system should help complete this process. A rate cut at this stage might have affected transmission because the market would have seen it as nearing the end of the easing cycle. The MPC has thus wisely chosen to preserve some policy firepower. Aside from inflation, the course of the monetary policy will depend on the Budget, which will be presented before the February meeting of the MPC. The government is in a difficult spot with mounting fiscal challenges. Sharp fiscal slippage in the current year, which is a real possibility, will constrain the MPC from further easing. Also, a pause at this stage shows that the MPC will use the available policy space judiciously.

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