There is a saying that wise men choose their friends carefully and, perhaps, their enemies even more so. But, occasionally, the lines get blurred. When viewed through the lens of an old aphorism—about keeping friends close but enemies closer—a slightly fuzzy picture about the country’s current economic management philosophy seems to be emerging.
It is early days yet, but the Reserve Bank of India (RBI) seems to be picking its bench of friends for the next year and, surprisingly, inflation might find a place on the list. Looking at all the tea leaves and coffee dregs, it might be fair to ask whether India’s central bank has become comfortable with a slightly higher level of inflation, albeit within its legally-mandated tolerance zone.
At its final bi-monthly monetary policy meeting for 2021-22, RBI decided to maintain the status quo by leaving rates well alone and retaining its accommodative stance. The policy stand remained unchanged, despite consumer inflation touching nearly 5.6% in December, a whisker’s distance from its upper tolerance limit of 6%. Bond markets and analysts, expecting some action on liquidity, were pleasantly surprised.
The central bank may have decided to run with its existing playbook because it feels that inflation rates might moderate by the first half of 2022-23, primarily due to expectations of a good rabi harvest and decongested supply lines easing food prices further. The central bank’s inflation forecast for 2022-23 at 4.5%, though, seems extremely hopeful and at odds with all other indicators (rating agency Crisil’s assessment is 5.2%).
But then, RBI does not rule out the risks entirely—from rising commodity prices, especially crude oil, or a domestic supply chain pregnant with the pass-through of elevated raw material prices. In the final analysis, the central bank’s dismal inhouse growth estimates for 2022-23’s second half (October 2022 to March 2023) may have also stayed its hands: 4.3% for October-December 2022 and 4.5% for January-March 2023.
In the trade off between combating a higher inflationary regime and fixing lower economic growth, the monetary policy committee (MPC) seems to have concluded that sputtering growth needs more attention. The central bank’s discouraging growth estimates also send out an interesting signal: the MPC seems to be expressing some scepticism about the budget’s large allocation for capital expenditure achieving the stated growth objectives.
Some quarters feel that a slightly higher inflation rate may not be so bad for the Indian economy, particularly for private consumption demand. Consumers tend to put off their purchases under a regime of falling prices, hoping to pick up bargains at a lower price later. When prices remain high for extended periods, inflationary expectations influence consumers to not postpone purchases. Economist John Maynard Keynes called this the Paradox of Thrift: low inflation over the long term encourages consumers to save more rather than consume, thereby dampening aggregate demand, leading to lower aggregate output and a weaker economy.
The US Federal Reserve, which has announced its intention to increase interest rates to squelch rising prices, is being asked not to use the sledgehammer and risk the US economic recovery. Nobel laureate Paul Krugman, who has been talking about tapping the brakes rather than slamming on them, wrote recently in The New York Times: “A temporary period of elevated inflation, followed by a return to normal, is actually the appropriate economic response to the peculiar stresses of recovery from the pandemic recession."
It must also be remembered that monetary policy usually works with leads and lags; any action by the MPC will take time to wend through the system and achieve the desired effect. So, timing is crucial. There is also a lot in the mix that is not yet clear. How does wage growth square with the inflation rate? Or, will corporate earnings grow faster than prices to enable meaningful debt management? What do rising prices mean for macro-economic management, particularly the conservative nominal estimates in the budget?
It might be necessary to clarify here that RBI does not endorse runaway inflation rates. The amended Reserve Bank of India Act enjoins the central bank and MPC to maintain the retail inflation rate at 4%, but within a band of 2-6%. A failure to keep to this designated band for three consecutive quarters would require RBI to explain itself to the Centre. RBI’s report card will have to detail the reasons for the failure to achieve its inflation target, the remedial actions proposed to get inflation back within the 2-6% band, and the time period by when that can be achieved.
The interesting part is that the Act says nothing about consumer inflation ranging over 4% but below 6% for extended periods. It is, therefore, quite likely that RBI may not balk if consumer inflation continues to stay between 5% and 6% for the near future.
RBI’s dashboard is currently cluttered with competing variables: a high inflation rate; a lingering output gap; lagging consumption demand; slow growth; sluggish credit offtake; a widening current account deficit; pressure on balance of payments and exchange rates. In anticipation of the coming storm, RBI will have to choose, much like ‘the impossible trinity’, which one or two parameters it wishes to control or influence. On current reckoning, it seems tepid growth looms largest on RBI’s radar.
Rajrishi Singhal is a policy consultant, journalist and author. His Twitter handle is @rajrishisinghal.
