RBI monetary policy: Tolerating inflation to give growth a chance

Two words encapsulate the outcome of the RBI’s December policy meeting: downplay and stealth.

The RBI downplayed both the growth recovery and the inflation risks. On growth, even though GDP has reached its pre-pandemic level, the RBI stressed that this is not yet durable. Private consumption and contact-intensive services such as trade, transport and hotels remain below their pre-pandemic levels, private investment remains sluggish and the RBI expects the output gap may take several years to close.

The RBI also downplayed the inflation risks. Its projection that CPI inflation will rise to a peak of 5.7% YoY in Q4FY22, from 5.1% in Q3 was said to be the result of base effects, with the trajectory forecast to moderate to 5% by H1FY23 and to 4.0-4.3% by end-FY23. The cuts in excise duties and weaker demand are seen supporting lower inflation. In consonance with this view, the RBI did not send any signals around future policy normalisation.

Meanwhile, liquidity rebalancing continued in stealth mode. The reverse repo rate was left untouched, perhaps because it is too strong a signal. However, increased VRRR auction amounts and the intention to absorb more liquidity via the auction route rather than the fixed rate reverse repo window is expected to raise the weight average reverse repo rate closer to the repo rate, such that an actual hike in the reverse repo rate, when it occurs, will likely be a courtesy. How this will be made effective though, remains to be seen. Banks continue to park liquidity under the fixed rate window and are not fully utilising even existing VRRR facilities. Moreover, overall banking liquidity remains in a substantial surplus.

On the whole, the key message from the December meeting is that monetary policy remains fully geared towards growth.

Sonal Varma

While we agree that growth is not yet durable, there are risks that inflation may be more durable than expected. Despite the drop in oil prices, there are many offsetting factors. Telecom firms have raised their charges. Margin pressures are resulting in price increases from FMCG to auto sectors. The pandemic has resulted in friction and wages have risen in low-end labour-intensive jobs in urban areas. Higher fertilizer costs are a risk to food price inflation next year. Inflation expectations have bumped up to a level that is consistent with CPI inflation at 5.0%, and higher policy tolerance of inflation risks further unanchoring of expectations. Meanwhile, the uneven growth recovery is a real challenge. In our view, this requires a health policy response to make the recovery more even, because the stop-start rules hurt the contact-intensive segments, and policymakers can look to provide targeted fiscal and financial support until then. Monetary policy is a blunt tool and is benefitting bigger firms a lot more than smaller entities. Tolerating higher inflation to give growth a chance can hurt consumption demand of lower income households much more because of the squeeze in real disposable incomes.

This growth-inflation trade-off is a tricky environment for policymakers. Over the last two years, tolerating high inflation to give growth a chance was the right strategy. However, the risks from continuing to overlook inflation are now starting to outweigh its rewards, in our view.

Ultimately, policy rates are like road friction: too much, and the tyres will wear out; too little, and the car can lose control.

The author is chief economist for India and Asia ex-Japan at Nomura