RBI's Hamletian dilemma

With the pandemic eating into the growth impetus of the Indian economy and associated supply shocks pushing up the inflationary pressure, the inflation targeting regime of the Reserve Bank of India (RBI) could be on the horns of a dilemma in the near future.

Depending upon the extent of adverse impact of the ongoing Covid-19 pandemic on the real and financial sectors, the economy may warrant loosening of the monetary policy, but if inflation — primarily emanating out of adverse supply shocks— goes out of control, then further easing of monetary policy could appear to be counter-productive. Thus, there are indications that the stage of monetary policy is being set for a classical Hamletian dilemma: To ease or not to ease monetary policy further.

To get to the context, it may be useful to remind ourselves that with the signing of the Monetary Policy Framework Agreement between the Government of India and RBI on February 20, 2015, flexible inflation targeting (FIT) was formally adopted in India. Subsequently, with the amendment to the RBI Act on May 14, 2016, several provisions of the framework were subsumed in the amended Act. The central government, in consultation with the RBI,  notified the inflation target of 4.0 per cent— with 6.0 per cent and 2.0 per cent as the upper and lower tolerance levels, respectively— in the official gazette on August 5, 2016. It was also specified that this inflation target is applicable from August 5, 2016, to March 31, 2021, and that if the average inflation is more than 6 per cent, or less than 2 per cent, for any three consecutive quarters, it would mean a failure to achieve the inflation target. 

If the RBI fails to meet the inflation target, it shall set out “a report to the central government stating the reasons for failure to achieve the inflation target; remedial actions proposed to be taken by RBI; and an estimate of the time-period within which the inflation target shall be achieved pursuant to timely implementation of proposed remedial actions,” the gazette notification added.

illustration: Binay Sinha

From the inflationary trends during the last seven years, it is clear that the FIT regime of the RBI has been quite effective and successful and inflation rate has been, by and large, within the tolerance limit of 4 per cent, (± ) 2 per cent, till November 2019 (see chart). Of course, good luck in the form of benign supply shocks (particularly low global energy prices) could have had a role in the sharp downward inflationary trends during some episodes.

Are the inflationary and growth records in recent months, following the pandemic, posing some issues for the FIT regime?  Following broad pointers are indicative. First, rates of inflation have been consistently higher than the 6 per cent mark, since December 2019 with the exception of March 2020, when it was 5.8 per cent. Given the limited lifting of the lockdown — and in some cases, its re-imposition— supply shocks may continue till there is a marked improvement in the Covid-19 situation in India.

Second, even before the pandemic, Indian growth had been decelerating over the last eight quarters, and the January–March 2020 quarter saw a low growth rate of 3.1 per cent. Rightly, monetary policy was in an accommodative mode even before the outbreak of the pandemic and the repo rate was cut by as much as 135 basis points between February 2019 and the beginning of the pandemic. Liquidity conditions have been kept in the surplus mode since June 2019.

Third, now with the adverse impact of the pandemic, there are apprehensions that the real GDP growth for 2020-21 could be in the negative territory. The International Monetary Fund in its June 25 projections has placed Indian growth for 2020-21 at (-) 4.5 per cent. If so, it is going to be the lowest growth rate in 40 years.


Fourth, faced with such a depressed economy, a sizeable monetary stimulus has been announced. RBI Governor Shaktikanta Das in a speech on July 11 revealed that the liquidity measures announced by the RBI since February aggregated to about Rs 9.57 trillion (equivalent to about 4.7 per cent of 2019-20 nominal GDP).

Considering all these stylised facts, any high inflation number (higher than 6 per cent) in future could pose a dilemma before the RBI — whether to prolong the stimulus, take a pause or start reversing the rate-cut cycle. It is our view that high inflation during the pandemic in no way should cast any doubt on the effectiveness (or the lack) of the flexible inflation targeting regime. These dilemmas are genuine in the life of any monetary policy regime and it is expected that the RBI will take an appropriate stance in sync with the incremental unfolding of the hugely uncertain reality in near-future.

The current pandemic is the perfect example of a black-swan event in its rarity and unpredictability.  Nobody could have predicted its outcome even as late as March. It will, thus, be best to place any monetary policy decisions in this troubled time under an escape clause similar to the Fiscal Responsibility and Budget Management Act that allows the central government to borrow more than the statutorily allowed limit during exceptional circumstances.  

A review of the Indian inflation targeting regime would be due next year. It will be appropriate to hold any verdict on its performance till that time. An interim assessment in an exceptional year could suffer from pessimistic biases and would be indicative of rash judgement.
The writers are professors at Indian Institute of Management Calcutta.

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