SynopsisIndia’s flexible inflation targeting introduced four years ago ties the central bank’s hands when it comes to interest rates as it is mandated to target the Consumer Price Index at 4 percent in a two percentage band on either side. To make its policy effective, the central bank kept liquidity in deficit. That has now turned to a surplus, estimated at Rs. 8 lakh crores.
MUMBAI: Whenever the Reserve Bank of India cut interest rates in the past, more often than not, stocks have fallen. But on Friday, when Governor Shaktikanta Das did nothing, stocks soared to a lifetime high. The reason? Liquidity!
India’s central bank joined monetary policy makers across the world who are keepsing interest rates at near zero and printing money, but unlike the developed markets India can’t afford to keep lowering rates, thanks to price pressures. But it is substituting with generous money that helps manage the optics on inflation targeting and at the same time stimulate demand.
India’s flexible inflation targeting introduced four years ago ties the central bank’s hands when it comes to interest rates as it is mandated to target the Consumer Price Index at 4 percent in a two percentage band on either side. To make its policy effective, the central bank kept liquidity in deficit. That has now turned to a surplus, estimated at Rs. 8 lakh crores.
When inflation is running at a six-year high of 7.6 percent, theoretically it becomes difficult to justify a policy interest rate of 4 percent and surplus liquidity. Many believe the latest forecast of 5.2 percent to 4.6 percent range may be optimistic.
When Parliament adopted inflation targeting as a monetary policy principle, it was to bring credibility to what the RBI did to preserve the value of Rupee after years of double digit inflation. Did it meet the goal? What are the risks of ignoring inflation to prop up growth?
“Everything is out the window,’’ says Ananth Narayan, Professor of Finance at SPJIMR. “The economy is still in stress. No one’s talking about inflation anywhere. This may not be the time.’’
It would be a crime to tighten monetary policy fearing inflation in a year when the economy is forecast to contract 7.5 percent. But at the same time, the chance of inflation challenging the easy monetary stance in the months ahead is real.
One of the main objectives of a shift to CPI was to bring down people’s inflationary expectations. But the RBI’s survey over the years shows that it hardly fell below 8 percent in a durable manner. Currently, it is running at double digits. If a tight monetary policy with a focus on 1 percent real interest rate couldn’t provide comfort, what happens if inflation remains stubbornly high?
While the current inflationary pressures may be attributed to farm prices and supply side glitches, what if they become entrenched? Remember Governor Duvvuri Subbarao’s tenure when easy policy lasted longer than required believing inflation was due to consumption of protein rich meat and eggs, but ultimately spread to a wider set of goods and services.
The risks of being complacent on inflation is not lost on the Monetary Policy Committee. After raising the inflation forecast, Governor Das said that there is “some evidence that price pressures are spreading. The outlook for inflation has turned adverse relative to expectations in the last two months.’’
He didn’t stop at that. “While cereal prices may continue to soften with the bumper kharif harvest arrivals and vegetable prices may ease with the winter crop, other food prices are likely to persist at elevated levels. Cost-push pressures continue to impinge on core inflation, which could remain sticky.’’
While this is the story on the farm side, what if capacity utilization improves with rising demand due to opening up, and companies hold back from creating fresh capacities and instead enjoy higher profit margins? Car makers are already complaining that higher commodity prices are squeezing them.
The enormous efforts of governments and central banks will fuel economic recovery next year. That’s the time when vaccine availability would bring people out boosting sentiment and making the real economy vibrant. But that’s not what the financial markets would have bargained for. The music is on, at least for now.
Views are personal