RBI must start focusing on inflation control – The Hindu BusinessLine

Clipped from: https://www.thehindubusinessline.com/todays-paper/tp-opinion/rbi-must-start-focusing-on-inflation-control/article65199566.ece

With the Ukraine war adding to inflationary pressures, RBI’s accommodative stance may no longer be tenable

The monetary policy committee in February 2022 voted unanimously to maintain status quo and keep the policy rate unchanged. With this, the policy rate has remained unchanged since May 2020. Clearly, the RBI’s dual objective of growth and inflation continues to lean largely towards growth, even as inflation risks continue to loom.

It is noteworthy that two of the key components of aggregate demand . — private investment and private consumption expenditure — have not spurred significantly from the ultra-low policy rate. In fact, the real private consumption expenditure in FY22, as per the first advanced estimates, stood at about 3 per cent below the FY20 levels. Private investments have also not revived, as the transmission of interest rate reduction to bank lending rates has remained limited.

Since January 2020, the policy repo rate has been lowered by 115 basis points, but the three-year simple average marginal cost of funds-based lending rate (MCLR) of scheduled commercial banks dropped by only 60 basis points during January 2020 to January 2022. The passthrough has been insufficient and revival in growth weak, necessitating a focus on a comprehensive toolkit for revitalising growth; but the spectre of inflation needs a more urgent attention.

Russia-Ukraine crisis

Russia’s invasion of Ukraine is likely to exacerbate supply side risks to inflation, as supplies from Russia, the largest natural gas exporter and the second largest oil exporter, are disrupted. International food prices could also spike as supplies of agricultural products from Ukraine are restricted on account of the invasion.

Alongside, the US Federal Reserve has officially announced the beginning of its monetary policy tightening and has indicated interest rate hikes and other measures aimed at controlling inflation. The hawkish shift in the Fed’s approach and the likelihood of the Fed raising its policy rate at least thrice this year, and by about 25 basis point each time would mean that the tightening of global financial conditions will be quicker this time, as compared to what was seen in the taper tantrum of 2013. Global financial markets are also in turmoil due to Russia’s invasion on Ukraine, with investments moving to safer assets.

India has also not remained immune to the global flight to safety of investments. Since November 2021, after the Federal Open Market Committee unanimously voted to scale back its asset purchases, India’s net FPI, both equity and debt, has been deteriorating steadily. More recently, during January 2022 till February 28, 2022, net FPI investments stood at (-) Rs. 665.9 billion.

Mirroring the Fed’s move, the much-anticipated tapering of asset purchases and hiking of policy rates by several central banks around the world have already commenced. For instance, the Bank of Canada has gradually tapered its asset purchases over the recent months. The Bank of England hiked its policy rate by 25 basis points to address the 30-year high inflation rates in the economy. Central banks in several emerging markets such as Brazil and South Korea have also hiked rates.

As systemically important central banks bring an end to the easy-money policy era and international capital moves to safer assets amid heightened uncertainty, potentially disrupting emerging markets, including India, it is important to examine whether India has adequate room for manoeuvring its policy.

Dealing with the policy trinity of managing volatility in exchange rates, open capital accounts and monetary policy discretion has become even more complex now. As the central bank can generally manage only two of these three aspects, a trilemma arises when they are forced to manage all three.

In the current scenario where the RBI cannot control the capital flows, and has decided to continue with an accommodative stance, the rupee would weaken rendering all imports, including crude oil and capital goods, more expensive. Servicing on foreign debt would also become more expensive.

The RBI could arrest a fall in the Rupee as it stands comfortably guarded with the fourth largest forex reserves and an improved reserve cover. But selling dollars could in turn increase money supply, and create inflationary pressures, if not accompanied by an efficient sterilising intervention. And hence, the trilemma.

But this is not just a trilemma, but a quadrilemma. The government gave a much-needed fiscal boost to the economy in the Union Budget, and the fiscal deficit has been larger than the expectation. If the rupee depreciates sharply, two of the biggest components of non-plan expenditure — interest payment and subsidies would swell.

If rupee depreciates sharply, external debt servicing cost would go up, moderating the advantage offered by lower interest regime for government borrowings.

The RBI’s accommodative stance may not be tenable for long in the light of rising inflation and the external sector developments. Fostering credibility in inflation targeting would be essential for price stability and pursuing the growth objective in an orderly and definitive manner.

The writers are economists with the Export-Import Bank of India. Views expressed are personal

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