The next hurdle

Governor Das has to take a call soon on unwinding stimulus

Shaktikanta Das assumed charge as governor of the Reserve Bank of India (RBI) two years ago at a distinctly difficult time. His predecessor left, almost 10 months ahead of his term, after a fractious faceoff with the government. The top priority for Mr Das was to bridge the deepening trust deficit, as the central bank and the government have to work together on a number of critical issues. Armed with the experience of serving in the finance ministry and his consultative style, Mr Das was able to settle the issues with relative ease, including the matter related to the central bank’s capital. But that’s certainly not the only challenge the governor has faced so far. 

Earlier this year, the RBI had to respond to an unprecedented crisis where a large part of the economy was deliberately shut down to contain the spread of Covid-19. It had to not only contain the economic damage, but also keep the payment system running, ensure smooth functioning of financial markets, and maintain financial stability. The RBI, along with other regulators, accomplished most of this. In fact, in terms of policy support, the RBI has done most of the heavy lifting. Responding to the crisis, it reduced the policy rate by 115 basis points, taking the total rate reduction to 250 basis points since February 2019. The central bank also flooded the system with liquidity, which has reduced market interest rates and allowed both the government and businesses to borrow at lower rates. Unwinding this massive support will be the next big challenge for Mr Das. 

Inflation has been running way above the tolerance band for many months now. Although consumer price inflation eased to 6.93 per cent in November, and a sharp decline in vegetable prices in December could provide some more relief, the level remains a worry. While it is clear that the RBI wants to support growth, sustained high inflation could be seen as a deviation from the inflation-targeting mandate. The business of deviation, even allowing for special circumstances, does not work as a credible policy framework. To be sure, much of the developed world is discounting the inflation risk. But India is not in a position to follow such a path. In fact, even in the developed world, economists have started talking about inflation risks. Former vice chairman of the Federal Open Market Committee Bill Dudley in a recent article, for instance, highlighted the reasons for possible higher inflation and noted: “...inflation might be a greater danger precisely because it’s no longer perceived as such.”

A quick look at global commodity prices suggests that inflation is already rearing its head. Asset price inflation, including high stock prices, is precisely what one gets with loose money supply and negative real interest rates. The problem for India is that inflation expectations had begun to come down, but might go up again because of persistent higher inflation and an unfavourable outlook. Thus, the main challenge for Mr Das will be to transition his way out of this situation. The price would be a higher cost of government borrowing, and he will need to be willing to displease the government. A considerable delay could lead to longer-term policy complications.