RBI's multiple challenges

Attaining different objectives could become more difficult

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) is meeting this week for the first time in 2021-22. The rate-setting committee is widely expected to leave the policy repo rate unchanged. The risk to economic recovery has increased significantly over the last few weeks with a sharp surge in Covid cases. Restrictions on movement in different parts of the country can affect supply chains. This would not only hurt economic recovery but also increase risks to inflation. The inflation rate remained outside the RBI’s tolerance band for several months in 2020, partly because of supply chain disruptions. Thus, the evolving situation can significantly increase policy complexities for the RBI. With renewed risks to economic recovery, it is possible that the RBI will be expected to maintain accommodative conditions for longer than previously expected. Meanwhile, inflation could increase not only because of domestic supply constraints but also due to the general rise in global commodity prices.

The Union government did well last week to retain the inflation target under the flexible inflation targeting framework. As a result, the RBI will need to keep the inflation rate based on the consumer price index at 4 per cent with a tolerance band of 2 percentage points on either side. Continuing with the target will provide policy stability and increase market confidence. It will also help the RBI anchor medium-term inflation expectations. However, this alone will not solve all the problems of the Indian central bank. The RBI has multiple objectives and, depending on the situation, some can become contradictory in the short run. If the inflation rate begins to rise — partly due to a pick-up in global commodity prices — along with weakening recovery, making policy decisions could become extremely difficult.

While the current mandate on inflation gives the central bank a fair amount of flexibility, it might have to sacrifice growth in the short run to maintain price stability and anchor medium-term inflation expectations. Further, the RBI also has to manage a large government borrowing programme in a non-disruptive manner. This would require maintaining high levels of liquidity in financial markets, which could affect inflation outcomes. But if it does not intervene in the bond market, borrowing costs will increase, which can crowd out the private sector and impede the recovery process. Therefore, the RBI will have to do a tough balancing act. The level of difficulty, of course, has risen because of a significant increase in government borrowing.

Meanwhile, the global conditions will only add to policy complications. Some countries in the developed world, particularly the US, are expected to recover from the pandemic strongly. Faster economic recovery in the US will increase global interest rates and tighten financial conditions. Capital is moving out of developing markets and countries such as Turkey, Brazil, and Russia had to raise interest rates recently. While India is better placed with a large foreign exchange reserve, tightening global financial conditions along with higher interest rates in the US can create volatility in financial markets and make policy management more difficult. An outflow of capital could result in rupee depreciation. Although this will benefit exporters, it could also add to inflationary pressure by making imports more expensive. Thus, while the MPC is likely to leave the policy rate unchanged this time, the overall policy management of the RBI will be tested in more ways than one this fiscal year.