And that, in a nutshell, was the crux of the Indian Monetary Policy Committee’s (MPC) dilemma when it met last week. Given the wide range of central bank responses across the world, what could possibly constitute the MPC’s holy grail? A rate hike, for sure; but by how much? 35 basis points, as suggested by some? Or a more aggressive 50 basis points, as urged by others (and subsequently favoured by the MPC)?
Compounding the MPC’s problem was the fact that, unlike in advanced countries, where soaring inflation has made taming the inflation beast top priority, even at the risk of tipping the economy into recession, the picture in India is more complex. Inflation appears to be softening, albeit very slightly—the high of 7.8% in retail inflation in April 2022 was followed by a 7.04% reading in May and 7.01% in June. But retail and wholesale price inflation remain unconscionably high and need to be reined in. Could that be done without impacting growth adversely?
No, say economists, who like to talk of a growth-inflation trade-off; any attempt to tame inflation through raising interest rates takes a toll on growth. Consequently, central banks resort to an interest rate bazooka (read, raise interest rates sharply) only in exceptional circumstances: When soaring inflation leaves them with no option; growth be damned. That is the position in advanced economies today.
In the Indian context, the picture is more nuanced. Signals on the inflation front, while seemingly encouraging, are not definitive. But this, combined with the fact that high frequency indicators suggest recovery is on track (though the recent slowdown in export growth suggests it could come to an early end), presumably, gave the MPC some ‘space’, in the governor’s words.
The “inflation trajectory is now poised at a decisive point," said RBI governor Shaktikanta Das. “While there are incipient signs of a confluence of factors that could lead to further softening of domestic inflationary pressures, there remain significant uncertainties. In such a milieu, with growth momentum expected to be resilient despite headwinds from the external sector, monetary policy should persevere further in its stance of withdrawal of accommodation to ensure that inflation moves close to the target of 4.0% over the medium term, while supporting growth."
Hence the MPC’s unanimous decision to continue the war against inflation (make up for coming late to the battlefield?), all guns firing. Front-loading the 50-basis points hike in repo rate (at which RBI infuses liquidity), thereby taking it higher than the pre-covid level to 5.40%, is a signal that the committee is serious about tackling inflation.
Fair enough! Except that the policy action doesn’t gel with the MPC’s long-standing position that inflation in India is largely supply-driven. A hike in interest rates to curb demand would serve no purpose, we were told in the past. This begs the question that if, indeed, inflation is mostly supply-driven and most of the risks to inflation today are emerging from external factors, higher global commodity prices and rupee depreciation due to foreign fund outflows, could a 50-basis points hike end up hurting growth, without doing much to rein in inflation?
Remember, monetary policy acts with a long and indeterminable lag. By RBI’s own reckoning, it takes two to three quarters for the effect of any policy action to filter through. Also, if by RBI’s reckoning inflation has peaked, can the 50-basis point hike make up for lost time? What can it hope to achieve? Not very much, perhaps! No wonder inflation estimates for this fiscal have been retained at 6.7%.
The sharper-than-expected hike could, however, hurt growth. Geo-political tensions are ratcheting up—the US-China face-off over Taiwan only adds to tensions over the war in Ukraine. Global demand is likely to weaken dramatically as the Eurozone and UK head into recession—the US is iffy—and the Chinese economy slows. In such a scenario, we can no longer count on exports, a main driver of growth in the last fiscal year, to shore up growth.
The external sector is already showing signs of weakness and the widening of the current account deficit (CAD) is clearly a cause of concern for RBI, as evident from the policy statement. If this year’s CAD crosses the 3% danger mark even as rising interest costs impact the government’s fiscal deficit, it could result in a return to the bad old days of the twin deficits—CAD and fiscal—upending the MPC’s carefully laid plans.
Would a more moderate 40 basis points hike and shift to a neutral stance have done a better job of balancing the growth-inflation trade-off? Of keeping stagflation (high inflation with stagnant but not falling growth) at bay? We’ll have to wait and see. For now, it’s hard to shake off the feeling that the MPC is framing policy on a wing and a prayer.
Mythili Bhusnurmath is a senior journalist and former central banker
