The consensus view among economists is that RBI’s Monetary Policy Committee (MPC) will vote to retain the policy rate at 6.5 percent in its meeting tomorrow. The rate has been at this level for 18 months, following a steep two-percentage-point increase between May 2022 and February 2023.
MPC’s decision on the interest rate and liquidity conditions are an outcome of the vote cast by its six members. At present, the decision to retain status quo on the rate is based on a majority of 4:2. Very likely, that will be the case in tomorrow's meeting.
If we consider the theory underpinning India’s Flexible Inflation Targeting (FIT) regime, along with the RBI’s analysis of the underlying drivers of inflation, there appears to be no justification for maintaining the status quo. The MPC should vote to start lowering the policy rate, as the reasons provided by the members favoring the status quo are inconsistent with both theory and data.
Interest rate is a tool to cap demand
On July 12, Michael Debabrata Patra, one of RBI’s deputy governors and a member of the MPC, delivered a speech to mid-career bureaucrats on monetary policy. The essence of his speech was that monetary policy is used to dampen aggregate demand and align it with productive capacity. It is a tool to manage short-run fluctuations in aggregate demand through interest rates and liquidity.
FlT can be distilled to three steps.
1. Diagnose the underlying cause of inflation. Is it driven largely by supply side factors or is it a case of excess demand?
2. If the answer to that question is excess demand, then interest rate can be used as a tool to curb it without undermining the economy’s productive capacity.
3. In the event inflation is mostly driven by supply side factors, the ideal response is to ignore it because interest rate is not the right tool to deal with it. The exception to the rule is that if the MPC fears that supply shocks will have a second round impact, leading to a broad-based price increase.
What the data tells us
RBI’s biannual Monetary Policy Report breaks down underlying drivers of inflation. The April edition of this report showed that beginning April-June 2022 quarter, supply side factors were the primary drivers of inflation.
The surge in inflation didn’t come from excess demand. However, in 2022 there was a reasonable ground for anxiety about the second round impact. However, that phase has long passed.
The recent rise in inflation has come primarily through food inflation. Given that food’s weightage is just a little less than 50 percent in the basket which goes into calculating the consumer price index, the majority of the MPC has opted for status quo. Food price shocks, it is feared, could feed into a more broad-based rise in prices.
The data, however, clearly shows that it hasn’t happened. Core inflation, which is what interest rates can curb, is at 3.1 percent, a record low. If the fear of a second round effect is correct, core inflation should have risen. It’s actually trended downwards for over a year.
Given that even more than the quantum of rainfall during the kharif season, it’s extreme weather conditions around harvest time that can influence food inflation, MPC could conceivably stick to status quo for an extended period. But that approach will be inconsistent with both theory and data.
MPC is way behind the curve—RBI’s inflation forecast for FY25 is 4.5 percent, well within its tolerance band.
Finally, MPC should not lose sight of the fact that even if India’s GDP in FY24 grew at a scorching 8.2 percent, private consumption expanded by the relatively weak 4 percent. That’s a sign of weak demand.
What’s the case then to keep voting to retain the repo rate at 6.5 percent?
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