The monetary dilemma

Financial markets expect the monetary policy committee (MPC) of the Reserve Bank of India (RBI) to cut the policy repo rate for the sixth time in the current cycle this week. Since growth in gross domestic product (GDP) slowed further to 4.5 per cent in the second quarter of the fiscal year, and growth in nominal terms collapsed to 6.1 per cent, with no clear sign of a strong revival, cutting policy rates would seem to be the logical choice. However, the decision is unlikely to be so straightforward. The MPC will need to consider a number of issues and the present economic backdrop will pose a big dilemma. 

First, the inflation rate based on the consumer price index (CPI) is expected to have crossed the 5 per cent mark in November and, according to analysts, is likely to remain elevated in the coming months. It is correct that the headline inflation rate has spiked largely because of vegetable prices and could be transitory in nature, which is also reflected by weak core inflation. The GDP deflator and inflation based on the wholesale price index are also at lower levels. But the central bank’s mandate is to target headline CPI inflation, and it will have to clearly communicate if it is willing to push real policy rates into negative territory and to what extent. In case food price inflation remains elevated for an extended period or gets generalised, as happened in the aftermath of the global financial crisis, that will affect the credibility of the central bank and managing inflationary expectations would become more difficult.

Second, so far in the current fiscal year, the RBI has taken the government’s word on fiscal management. This needs to change. Given the revenue position, it is becoming increasingly unlikely that the government will be able to stick to the stated fiscal deficit target of 3.3 per cent of GDP. Even if the government shifts some of its liabilities to public sector undertakings, aggregate borrowing is likely to go up. Further, it is likely that states will also witness significant fiscal slippage in the current year. All this will have a bearing on monetary policy. The government’s fiscal position is one of the biggest reasons for poor policy transmission. For instance, despite abundant liquidity in the system, the gap between the policy repo rate and yields on 10-year government bonds is about 130 basis points, partly because the market doesn’t believe that the government will meet the deficit target. 

Third, in the given context, the MPC would do well to deliberate over what it intends to achieve by cutting the policy rate one more time. Differently put, the effectiveness of monetary policy in the given context needs to be questioned. The transmission will become stickier because financial markets would factor in the declining possibility of future rate cuts. Thus, the MPC should be conscious of the limitations of monetary policy in the given situation. However, on the other hand, not cutting the interest rate at this point could unnerve financial markets and push up bond yields. Therefore, on balance, members of the MPC might choose to vote for a cut, but the central bank should clearly communicate the risks involved and limitations of monetary policy in the given economic situation. Reducing policy rates is not an end in itself.

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