Stay the course

RBI should not stop the normalisation process

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) is expected to keep the policy rate and stance unchanged in its bi-monthly meeting this week. The economic outlook, however, has become far more uncertain in recent days. A new variant of Covid-19, named Omicron — first discovered in South Africa — is said to be more contagious than the Delta variant, which was partly responsible for the deadly second wave in India. Although scientists might take some more time to gauge the potential consequences, the World Health Organization has called it a “variant of concern”. The resultant uncertainty has increased volatility in financial markets. This came at a time when the global economic recovery was anyway said to be losing steam. A renewed surge in Covid-19 cases globally would increase macroeconomic risks with implications for growth, inflation, and government finances.

The inflation rate based on the consumer price index has moderated in India over the past few months and would be a source of comfort for the rate-setting committee, though part of the decline is due to the base effect. Reduction in taxes on petroleum products by both the Union and state governments, along with the recent decline in crude oil prices, should help contain inflation to some extent. Core inflation, however, has remained sticky. It is likely that a potential surge in infection in different parts of the world would not only affect demand but also cripple supply chains that were being rebuilt over the past several months. Price pressures, therefore, might increase, leading to higher inflation. Notably, US Federal Reserve Chairman Jerome Powell told lawmakers recently that the risk of higher inflation had increased. Mr Powell had maintained thus far that higher inflation in the US was transitory. But he now believes that it’s perhaps time to retire this word.

Financial markets are now expecting the Fed to taper its asset purchase programme at a faster pace and move toward increasing interest rates. The inflation rate in the US is running way above the target of 2 per cent and was at 6.2 per cent in October, a three-decade high. Although the world is learning to live with the virus and its impact on mobility and economic activity has declined considerably compared to the initial phase, it would still affect growth and supply chains. This would naturally increase complications for policy managers. The RBI has also termed the post-pandemic higher rate of inflation transitory. Although the rate has come down, it is expected to move up again.

The RBI has rightly started the policy normalisation process and stopped its bond-buying programme to manage yields. It has also increased the absorption of liquidity under the variable rate reverse repo window. The next step for the central bank will be to normalise the policy corridor by increasing the reverse repo rate. It may choose not to do this in one go and give the markets more time to adjust. The government intends to spend more than the budgeted amount and this could possibly increase its borrowing requirement, which would affect bond prices. The RBI should allow the prices to adjust. The policy normalisation process at this stage is outside the purview of the MPC and the RBI would be well advised to stay the course. Stopping or delaying the process will create confusion and affect policy credibility.