The monetary policy committee (MPC) has retained the key rates in its policy review amid the pandemic worries. It has voted for growth, ignoring the near-term pressure on inflation. The MPC has largely affirmed the guidance it gave in the October policy—to continue with the ‘accommodative stance’ as long as necessary to support growth. It has opted for status-quo in the last few policies despite being in an ‘accommodative’ stance.
Now the key question--can the MPC cut rates going ahead (which is what the stance suggests) or shift focus to inflation management that is clearly not the focus now? High inflation prevents the MPC from easing the policy rates no matter what stance it takes. There are five key points here:
1) The MPC has taken extra care to make the policy sounds as a growth supportive one. That is a clear signal to the markets that there is a possibility of more growth-supportive measures going ahead. During the policy announcement, RBI governor Shaktikanta Das emphasised the part that the central bank is willing to do whatever necessary to make sure enough liquidity is available in the market, using all instruments at disposal.
The guidance clearly states that the policy is tuned towards reviving growth and tackle the impact of Covid-19 on the economy. Das is optimistic that there is recovery in both rural and urban segments but sustaining this will need policy handholding. This means that there is still no confidence on the part of the central bank about the growth situation and a rate cut is still a possibility.
2) The central bank seems to be absolutely fine with extra low short-term rates in the market. With abundant liquidity floating around in the market, mutual funds have been parking money at below 3.35 per cent (the reverse repo rate) in the papers of top rated corporates in the past few days. But, there was no mention from the central bank about draining excess money from the market.
In fact, many economists expected this will be part of the policy today. It appears that the RBI doesn’t want to upset the market sentiments with respect to liquidity situation for the time being. Yet again, a positive signal that shows MPC’s growth supportive stance.
3) The MPC has noted that inflation risks remain high. The high inflation projections, seen along with the promise of continuing 'accommodative stance' is bit perplexing. Inflation projection has gone up substantially signaling that the MPC will have to rethink on policy stance if price pressures stay high going ahead.
The MPC now projects CPI inflation at 6.8 per cent for Q3 of 2020-21, 5.8 per cent for Q4 of 2020-21 and 5.2 per cent to 4.6 per cent in H1 of 2021-22, with risks broadly balanced. If inflation stays high of the MPC, it may have to look at tightening rates or at least stay on hold for a longer period.
During the presser, Das said he will be continuously watchful of inflation and take appropriate actions ahead. During the presser as well, governor said inflation remains at the top of agenda but Covid-19 warrants special attention on growth.
4) Thus, growth is the biggest worry at this point, not inflation. But, what happens ahead also depends on how the recovery shapes up. The MPC has improved its forecast on economic growth to –ve 7.5 per cent in FY21 compared with the earlier estimate of -9.5 per cent. A quick recovery on growth will give comfort to the MPC to focus more on the inflationary pressures.
Question is if the expected recovery will continue. The MPC has clearly indicated that it is of the view that growth needs supportive policy measures but high inflation constraints the policy to act. It has also noted that the economic recovery is far from broad-based at this stage. Essentially, what it means is that if inflation eases, the MPC could still offer rate cuts.
5) There is a fear that excess liquidity can spur inflation. But, the RBI is of the view that inflation is a supply side issue. In the policy, the MPC said a small window is available for proactive supply management strategies to break the inflation spiral being fuelled by supply chain disruptions, excessive margins and indirect taxes. Further efforts are necessary to mitigate supply-side driven inflation pressures. Monetary policy will monitor closely all threats to price stability to anchor broader macroeconomic and financial stability. How the supply side inflation pans out in the next few months will be critical.
During the post-policy presser, RBI's Das said the central bank hasn't 'junked' its mandate on inflation management but pandemic situations warrant focus on growth. The RBI's primary responsibility is price stability but worrying growth situation has paused a dilemma.
In short, MPC is caught between a a rock and a hard place in its policy choice. MPC’s promise of easing policy rates (suggesting it has room to do so) will entirely dependent on inflation trajectory. While the policy stance continue to be accommodative in support of growth, the MPC will be forced to reverse the future policy course if inflation continues to play spoilsport.