As growth recovers, it will need to address other policy issues
The Reserve Bank of India’s (RBI’s) Monetary Policy Committee (MPC) on Friday decided to leave the policy rate unchanged, as was widely expected, in its last policy review of 2020. The committee also revised its inflation and growth forecasts, and both surprised on the upside in recent months. The committee expects the Indian economy to break out of contraction in the current quarter and post a positive growth rate of 0.1 per cent, followed by another expansion of 0.7 per cent in the next quarter. Its view on inflation has changed significantly compared to the last meeting. The MPC now expects the inflation rate to average 6.8 per cent in the current quarter and 5.8 per cent in the next quarter. Notably, inflation is likely to remain above 4 per cent — the midpoint of the target band — at least till the first half of the next fiscal year.
Additionally, the MPC resolution noted that besides a transient relief in the winter months, the inflation rate was expected to remain elevated. However, the tone of the MPC resolution and the post-policy media interaction of the RBI brass suggest that the central bank is more concerned about supporting growth. To be sure, the RBI has done most of the heavy lifting in terms of providing support to the economy, which is affected by Covid-related disruption. The fiscal policy support has been muted. The central bank has reduced interest rates, flooded the system with liquidity to help ease financial conditions, along with regulatory interventions to provide relief to both borrowers and lenders. But it may not be able to continue this indefinitely. While the central bank has decided to support growth for now, it will need to address other policy aspects soon in 2021.
For instance, excess liquidity in the system has pulled short-term rates below the reverse repo rate. Although this might look supportive at the moment, it could create risks. Further, one of the biggest drivers of liquidity is the RBI’s intervention in the currency market to absorb excess foreign flows, which will need to be continued to protect the external competitiveness of the rupee. India is likely to have a significant balance of payments surplus in the next year as well. However, it is not clear how the RBI intends to mop up the resultant rupee liquidity. The reverse repo window doesn’t seem to be adequately addressing the problem. A higher level of liquidity is helping borrowers, including the government, which is likely to have a relatively large borrowing programme even in the next fiscal year because it will not be possible to reverse the deficit expansion in one go. However, maintaining significant excess liquidity for an extended period could affect inflation outcomes as the economy recovers.
Furthermore, the RBI would do well to study the nature of inflation in detail, including the kind of supply constraints pushing up prices even as output is recovering. Also, how would inflation behave in the coming months if a vaccine is available for a critical mass of people, which will increase mobility and demand? The MPC and RBI must address these issues quickly. The Indian central bank should not be seen as willing to ignore inflation risks because this will affect the credibility of monetary policy. This could have longer-term implications, particularly at a time when medium-term potential growth is estimated to have come down significantly.