The August 6 review of monetary policy seems to have left markets and analysts unconvinced about the Reserve Bank of India (RBI)’s views on inflation. The central bank, which again revised up its inflation projections for the third successive review to 5.7 percent for 2021-22 from 5.1 percent in June, retained its growth forecast (9.5 percent) and the accommodative stance.
As before, and through the duration of the pandemic, it reasserted the price growth is ‘transitory’, induced by supply-side pressures, and that ‘a pre-emptive monetary policy response’ could be counterproductive at this stage. However, the doubling of liquidity absorption through variable reverse repo rate (VRRR) auctions from Rs 2 trillion to Rs 4 trillion by September and an MPC member’s dissent over the stance has been interpreted as the beginning of policy normalisation, though the RBI Governor emphasised to not regard it such, and that it remained in whatever it takes mode to steer a durable recovery.
The steady upward revisions of inflation projections, that it is expected above-target into the next year (5.1 percent), and rising inflationary expectations have created an impression the RBI is excessively pro-growth, somewhat neglectful of inflation. Particularly because of the steep rise in inflation expectations — a respective 50 and 60 basis points at three-months and 1 year-forward duration to 11.3 percent and 11.5 percent in July — and their alignment to non-food products and services, there’s concern that overlooking these signs could be costly. The underlying fear is of entrenchment, that inflation expectations could get dislodged if temporary price increases persist for too long.
To be sure, these concerns are not invalid. When poised against inflation that has remained firmly high for more than one year, any central bank is confronted by the hard choice of apportioning weights between the two objectives. In this instance, the exceptional frictions caused by the pandemic are pitted against an outsized negative output gap that leaves no scope for doubt about the absence of demand pressures.
The visibly depressed labour market or high unemployment points out the wage links are non-existent. When the pandemic is still at large, weighing price distortions induced by short-term shortages and disruptions against the output recovery objective, the die is cast in favour of the latter.
In this light, the RBI seems surer of inflation than the near-term recovery path. With the first quarter’s performance clearer by the time of the review, the growth forecast was revised up 2.9 percentage points to 21.4 percent from18.5 percent earlier. But for the remaining three quarters of this year, the central bank now foresees real GDP to grow more slowly at 7.3 percent, 6.3 percent and 6.1 percent respectively, lower by 60, 90 and 50 basis points than in June.
The RBI seems to think a pre-mature monetary response or normalisation could harm growth more than the loss from falling behind the curve and risking inflation gaining a toehold. Any step in this direction, howsoever small, would distinctly change the environment; make the interest rates ratchet up unavoidable. Against this, the elevated inflation expectations can still be watched for dangers of entrenchment; there are signs for example, that international commodity prices have peaked, while recoveries in some major economies are threatened by spread of the COVID-19 Delta-strain.
The balance between inflation getting embedded into the economy or straining it too early with higher interest costs in weak conditions revolves round the perceived potential. It is possible the differences in judgment about inflation risks lie in the estimates of potential output — most analysts take this to be around 6 percent, while the RBI never shares its own estimates.
A stronger economy would bounce-back faster due to greater resilience of households and businesses with more spending power. A weaker economy, by contrast, say a lower potential, would take longer to get back to its feet.
Those who believe the output gap will narrow more quickly with the post-lockdown rebound probably underscore the existing economic health is solid enough for that. But it seems the central bank is less optimistic and considers the economy to be more fragile — a weaker state takes longer to recover from shocks and catch-up to where it was before the pandemic, i.e. 2019-20 that was already a year of significant decline in the growth rate to 4 percent.
That explains why the central bank is wary of trapping the economy in a low-growth situation for a longer period. Under the exceptional circumstances it faces, the pro-growth stance is probably the best course.
Renu Kohli is a New-Delhi based macroeconomist. Views are personal and do not represent the stand of this publication.