RBI’s monetary policy about-turn: Will it actually tame inflation?

After ignoring consumer price inflation for some months (wholesale price inflation has also been extraordinarily high for long) under the illusion that it was transient and will subside on its own, the Reserve Bank of India finally changed course on 4 May and decided to do something to control rising prices.

RBI took three measures:  it raised the price of short-term funds it lends to banks (repo rate in central bank jargon) by 40 basis points to 4.4 percent, sequestered additional 50 bps of banks’ lendable funds by raising non-remunerative CRR (RBI pays no interest on such deposits) to 5 percent and announced it will focus on withdrawal of accommodation while remaining accommodative.

Monetary theory stipulates that central banks can nudge banks to raise interest rates by increasing the cost of central-bank short-term funds which then stifles demand for loans. This, in turn, reduces consumption and investment demand restoring demand-supply equilibrium and finally, taming inflation. Likewise, it is argued that when CRR is raised, banks’ lendable funds are effectively reduced, curtailing the supply of loans.

RBI, by hiking repo rate and CRR, expected to contain credit growth and singe inflation.

RBI’s decision to continue with an accommodative stance, while beginning the withdrawal of liquidity, however, keeps it ranged in the opposite direction. If RBI keeps supplying excessive liquidity/accommodation to banks by maintaining an accommodative stance, sequestering of lendable funds via CRR hike, gets effectively neutralised. The banking system remains in excess liquidity, though the cost of funds goes up for banks. In a surplus liquidity situation, banks will not borrow from RBI, making a repo rate hike quite ineffective.

In a nutshell, RBI could only send confused signals to banks and markets on 4 May.

Why did RBI do so?

RBI’s primary responsibility, after amendment of RBI Act in 2016, is to maintain price stability (defined as maintaining CPI inflation in a corridor of 4 percent plus/minus 2 percent).

RBI, under Governor Shaktikanta Das, has, however, adopted two other objectives as its preferred objectives/missions.

Supporting GDP growth is the first one and has been consistently articulated as RBI’s preferred goal since Shaktikanta Das took over in December 2018. The second one, reflected more in action, is to ensure smooth financing of a large government borrowing programme at low interest rates fulfilling RBI’s role as the government’s debt manager.

RBI’s May 4 policy action is an attempt to serve its three objectives.

RBI tracks CPI, which though deals with only part of inflation problem (WPI has witnessed double-digit inflation for many quarters). CPI had also entered the upper inflationary corridor (between four and six percent) for many months. However, RBI kept ignoring this. RBI had to act when CPI inflation crossed 6 percent decisively in March. That explains raising repo rate by 40 bps and also the CRR.

RBI, however, did not want to hurt the nascent growth or jeopardise financing of the government borrowing programme. This made RBI announce that it will remain accommodative. This will allow RBI to buy government bonds to address any ruffled feathers. Surplus liquidity in the system will allow the veneer of serving the growth objective as well.

RBI hopes to juggle these contradictory objectives.

Wither now?

The two years since onset of Covid-19 were benign from an inflation perspective as both consumption and investment demand remained suppressed.  With no inflation worries, RBI could flood financial markets with liquidity. Though credit growth remained muted, abundant liquidity ensured smooth financing of the government borrowing programme.

Demand-supply in real economy has changed a lot in the last few months thanks to several factors.

Higher commodity and wholesale prices, caused by higher exports and changed dynamics of food and fuel economy courtesy Russian-Ukraine war, has resulted in higher demand for loans by manufactures, construction agencies and home-buyers. Consumer inflation for April is likely to cross 7 percent and stay high for quite some time.

RBI has begun only a reluctant and diffident battle on inflation by its May 4 policy action, which is unlikely to deliver.

If RBI wants to make difference, it will have to shed its internally inconsistent approach of achieving a trinity of conflicting objectives— putting out the inflation fire, fuelling growth and getting government borrowing financed at low rates of interest.

Inflation is an expectations phenomenon. Raising repo rates by half a percent three-four times in the remaining months of current financial year might be necessary.

RBI will also have to get out of the mumbo jumbo of ‘remaining accommodative while focussing on withdrawal of accommodation’ and pivot to a clear deficit liquidity/non-accommodative stance. This will though raise the cost of financing the government’s large borrowing programme.

Inflation works to the government’s overall fiscal advantage but is politically devastating as the vast majority of people suffer. RBI might do well to focus on inflation only for now.

The writer is Chief Policy Advisor, Subhanjali, and former finance secretary, Government of India.

Views are personal and do not represent the stand of this publication.