The policy response appropriate for inflation caused by excess demand would be wholly unsuited for inflation caused by supply disruptions and a spike in energy prices.
The Monetary Policy Committee of the RBI should neither raise policy rates nor wind up its accommodative policy stance. Yes, inflation has been on the rise, and growth has been setting in. This is the time to consolidate growth, not to be spooked by transient, supply-constrained inflation. Choking off supply-side price shocks is self-defeating. Higher prices will curb demand and stimulate additional supplies, if the prices are allowed to work their way through the system, instead of being choked off through demand suppression. It is only the second-order effects of price shocks in energy, logistics and labour that call for curtailment of demand via higher interest rates.
Far from there being any sign of excess demand, the latest available national income figures suggest squeezed consumption and constrained investment. GDP this fiscal would struggle to recover the size attained at the end of 2019-20. The policy response appropriate for inflation caused by excess demand would be wholly unsuited for inflation caused by supply disruptions and a spike in energy prices. The right way to combat elevated inflation right now is to reduce the burden of taxes that energy bears in India. Both the Centre and the states should share the tax cuts. They should take this action, even as they strive to find common ground on bringing energy under the goods and services tax. The government also has the cushion of relatively high import duties that can be pared, to lower prices. Stepping up production to increase supplies is another part of supply-constrained inflation.
There are measures the RBI can take to increase access to credit by micro, small and medium enterprises, other than enhancing liquidity in general in the hope that some would find its way to the small sector. The RBI can do its bit to realise the government mandate for all large companies to purchase their inputs from the Trade Receivables Discounting System (TReDS), for example. If that improves trade finance significantly, some reduction in liquidity would not matter.