RBI’s growth-inflation balance to get tougher

On April 6, the monetary policy committee (MPC) of the Reserve Bank of India will begin its meeting to deliberate on the course of interest rates and other aspects of monetary policy in the Indian economy for the following two months. The result of these deliberations will be announced on April 8. The global economic landscape has undergone a major disruption since the previous meeting, which ended on February, because of the Russian invasion of Ukraine. It has pushed up prices of important commodities, including crude oil, and made them volatile. The inflationary shock and uncertainty because of the Ukraine war is likely to generate headwinds for global growth as well. As a major energy importer, the Indian economy will not be isolated from these effects. All this will make the Reserve Bank’s challenge of balancing inflation with growth even more difficult. Here are three charts which explain this in detail.

Economic recovery is still below MPC’s expectations

While predicting 7.8% GDP growth for 2022-23 in February, the MPC observed it was lower than desired levels. “MPC judges that the ongoing domestic recovery is still incomplete and needs continued policy support. It is in this context that the MPC has decided to keep the policy repo rate unchanged at 4% and to continue with an accommodative stance as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of Covid-19 on the economy, while ensuring that inflation remains within the target going forward.” The repo, or repurchase rate is the rate at which RBI lends to banks.

The emphasis on policy support to “revive and sustain growth on a durable basis” has become a regular feature of MPC resolutions after the pandemic. MPC or RBI officials have never quantified this target.

Economists believe the forthcoming MPC will make a downward revision to its growth forecast. A research note dated April 6 by Samiran Chakraborty, chief economist, India at Citi Research, says the meeting is likely to revise its growth forecast from 7.8% to 7-7.5%.

Latest Purchasing Managers’ Index (PMI) data supports the argument about a deceleration in the growth momentum. Manufacturing PMI came at 54 in March 2022. While this is higher than the critical threshold of 50 (it signifies expansion over last month’s economic activity), the latest value is lower than the February value of 54.9. “Business conditions in India improved in March, but the latest results showed slower expansions in factory orders and production as well as a renewed decline in new export orders,” S&P Global, the agency which conducts the PMI survey in India, said in a statement. “Inflation concerns meanwhile dampened business confidence, which fell to its lowest level in two years,” it added.

But inflation and inflation expectations are likely to have regained momentum

After staying unchanged from November 2021, prices of petrol and diesel have increased by ₹8.4 per litre between March 22 and April 4. This will generate fresh momentum for inflation in the country.

The benchmark inflation number, as measured by the Consumer Price Index (CPI), has been rising for five consecutive months since October 2021 and crossed the upper limit of RBI’s tolerance band of 6% in January. At 6.06%, the February inflation was marginally higher than January’s.

What will perhaps be more perturbing for the MPC members is the possibility that inflation expectations of households – the entire inflation targeting framework is based on managing inflation expectations – are likely to have risen once again. Data from the Households’ Inflation Expectations Survey of RBI shows that three-month and year-ahead inflation expectations of households fell marginally between November 2021 and January (the period when fuel prices were not rising).

A sharp increase in inflation expectations, assuming the latest survey has been done after fuel prices started increasing, will make the challenge of controlling inflation more difficult for the central bank. Previous resolutions of the MPC have called upon both union and state governments to bring down taxes on fuel to bring down prices.

But will rate hikes help control prices?

The mandate to control inflation under the inflation targeting framework is not an end in itself. It is supposed to be a balancing mechanism vis-à-vis growth. The inherent logic behind a growth-inflation trade-off is that raising interest rates increases the cost of buying goods and administers a demand shock to an overheated economy. However, this logic need not hold when supply side factors (such as the high price of crude oil prices in the international market) are driving inflation instead of demand side factors.

“However, RBI is likely to emphasize that the source of inflation is primarily “supply side” and the MPC might not have very effective tools to address such inflation shocks,” Citi’s Chakraborty said.

While there might be merit in this argument, it does not take away from the fact that persistence of high inflation might continue to chip away at the purchasing power of consumers, especially those who are not well off. This is best seen in the growth (or lack of it) in real rural wages, which are a useful metric to track incomes of unskilled workers in the economy. The poor, because they consume a larger share of their incomes, are crucial for revival of demand in the economy. Such a situation, if left unaddressed, has the potential to create stagflation (low growth, high inflation) in the economy. It is exactly this ominous possibility which MPC will have to guard against in its deliberations.