Risks beyond growth

RBI should not undermine the price and financial stability objectives

As expected, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) has unanimously decided to leave the policy repo rate unchanged. It also decided to maintain an accommodative stance to support growth. The risk to economic recovery has increased significantly over the last few weeks owing to a rapid surge in Covid-19 cases. Restrictions being imposed by various states to contain the spread will affect demand. In the given context, the RBI has done well to maintain the status quo. However, the policy path may not remain as straightforward in the coming quarters. The surge in Covid cases and international financial conditions can significantly increase uncertainty.

The central bank has retained its gross domestic product growth forecast of 10.5 per cent for the current fiscal year. While this is lower than the latest forecast by the International Monetary Fund (IMF), the unpredictable nature of the virus, despite the ongoing vaccination programme, could increase risks to growth. Meanwhile, the MPC’s projections show that the inflation rate will remain above the 4 per cent target in the current fiscal year. Although it is expected to remain within the tolerance band, supply chain disruptions in various parts of the country could pose a significant risk, in addition to a general pick-up in global commodity prices. The IMF’s primary commodity price index increased by 29 per cent between August 2020 and February 2021. Potential higher inflation with weaker than expected growth could make things difficult for the RBI. 

Increased risk to growth means that the central bank would have to maintain accommodative financial conditions for a longer period. This would also be necessary to conduct the government borrowing programme smoothly, but can increase risks to inflation. The average surplus system liquidity in recent months was to the tune of about Rs 6 trillion, and the RBI has committed to maintain ample liquidity. The central bank is putting in place a “secondary market G-sec acquisition programme” where it will commit the level of open market operations (OMOs) upfront. Under this, the RBI will purchase government bonds worth  Rs 1 trillion from the secondary market in the first quarter of this fiscal. So far, the central bank had been announcing standalone and special OMOs to bring down yields. The idea clearly is to support the government borrowing programme and contain market rates to the extent possible. Bond yields did come down after the announcement. However, the commitment to maintain excessively accommodative liquidity conditions could make policy adjustment more difficult in case of a pick-up in inflation.

Besides, the RBI has to manage spillovers from the global economy. Faster than expected recovery in some of the advanced economies — particularly the US— has raised inflation concerns. Notably, the IMF’s latest World Economic Outlook argued that the price pressure would be muted. It further said that the risk of runaway inflation has decreased because of improvement in monetary policy framework, including in developing countries, though the progress is not uniform. But it also noted that “if monetary policy is used primarily to keep government borrowing costs low (or is widely perceived as doing so) at the expense of ensuring price stability, inflation expectations and inflation could, in principle, increase rapidly.” This is something that the RBI will need to be careful about. Supporting growth and government borrowing should not undermine the price and financial stability objectives.