RBI Policy | Don’t expect inflation to go away just yet

The RBI vowed to ‘remain focussed on withdrawal of accommodation’ but this ‘policy of gradual withdrawal’ is intended more to keep growth humming. (Representative image)

After fiddling with low inflation projections (4.5 percent in February, and 5.7 percent in April), the Reserve Bank of India (RBI) finally accepted the gravity of consumer inflation and raised 2022-23 inflation projection to 6.7 percent, which is much above the outer tolerance limit of 6 percent.

To show its intent to contain inflation, and as widely expected, the RBI delivered the ‘no-brainer’ 50 basis point increase in the repo rate — the interest rate at which it lends money to banks.

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Money and credit growth do play significant role in inflation/growth dynamics. The RBI, using indirect language, decided to keep the money supply tap on. It vowed to ‘remain focussed on withdrawal of accommodation’ but this ‘policy of gradual withdrawal’ is intended more to keep growth humming.

Inflation has become a very serious problem in India. Wholesale inflation has been around 13-15 percent for about a year. Consumer inflation reached nearly 8 percent in April, and is expected to stay elevated for quite some time.

High inflation poses serious risk to political stability, and re-election of the party in power. The RBI is expected to play a significant role in taming inflation.

Is the RBI policy action par for the course for containing inflation?

Inflation Problem Is Bigger Than CPI

The RBI targets inflation measured by the Consumer Price Index (CPI). The CPI measures inflation in only consumption goods and services like food, clothing, education, and health.

The universe of goods and services produced and consumed is much larger. There are capital/investment goods and services used in construction of assets like buildings and warehouses. In India about 70 percent GDP is consumption goods; the rest is investment goods.

The RBI does not target investment goods inflation. There is no good investment goods inflation index either. Investment goods make only about one-fourth of the composition WPI, which is a mishmash of consumption and investment goods. The RBI ignores WPI inflation.

The CPI is really not amenable to the RBI policy action. It is made up of 54 percent agriculture goods, predominantly food, 15 percent fuel, light, transport and communication services, 10 percent housing rent, and 10 percent health and education services.

Producers and consumers of the CPI basket of goods hardly avail credit. The RBI policy action works through credit channels. The CPI inflation is, thus, mostly immune of the RBI policy action.

There is another deeper reason why the RBI monetary policy action is ineffective in handling inflation in India. Inflation results from demand outstripping supply. Demand is made up of three basic constituents — incomes, transfers, and credit.

Income dynamics depend on more wage-oriented growth/de-growth of real economy. Transfers are largely fiscal function. The RBI can only influence credit, and not income and transfers. It, therefore, is in no good position to influence demand.

Supply is a more real economy and government policy function than demand. Supply-side disruptions have affected India as well. The government has also altered certain policies, e.g. export duties have been raised and import duties reduced for steel industry, which is impacting supply. The RBI, however, has no influence on supply dynamics.

The central bank has some real limitations in dealing with inflation. Unlike monetarists who believe that inflation is a monetary phenomenon, we should temper our expectations.

RBI’s Instruments Are Quite Weak

The RBI has several objectives — controlling inflation/maintaining monetary stability, spurring growth, managing external value of rupee, managing government borrowing programmes, and generating surpluses to maintain its capital adequacy and transfer hefty surpluses to government.

Shorn of fancy names — QT/QE, LAF, TLTRO etc. — the RBI, at the core, has only two instruments to serve its objectives, including inflation targeting: setting interest rates, and calibrating money supply.

A 50 basis point increase in the repo rate should in most circumstances raise interest rates. In fact, interest rates have already risen far above than what the RBI repo rate might indicate. The 10-year central government bonds are hovering around 7.5 percent. Banks’ lending rates are much higher.

Even if interest rates rise further, these are unlikely to make any difference to the government’s borrowing programme. Further, credit demand has seriously picked up (12 percent year-on-year growth in May 2022) for many considerations. The repo rate hike does not seem likely to make any impact on credit growth either.

The RBI has maintained surplus liquidity (Rs 5.4 lakh-crore in May 2022) which is not in step with the objective of controlling inflation.

The RBI’s two weak instruments, working at cross purposes, have weakened the fight against inflation.

RBI Policy Action Will Hardly Make Difference

In certain situations, monetary policy can have an over-bearing influence.

The central banks can dry up money and credit supply massively to neutralise impact of loose fiscal transfers by following deficit liquidity policy and raising interest rates extra-ordinarily high. Such policy framework can kill inflation, as Paul Volcker did in the United States in 1980s.

The RBI today did not wield this kind of sledgehammer.

Effectively, the RBI continues to soft-pedal interest rates and keep liquidity in surplus. The policy of gradual withdrawal may last many MPC meetings.

Monetary policy action taken on June 8 is more pro forma and will hardly make any difference to the inflation trajectory in India.

Subhash Chandra Garg is an ex-IAS officer of the 1983 batch, former Finance and Economic Affairs Secretary, Government of India, and author of The $10 Trillion Dream. Views are personal, and do not represent the stand of this publication.