Time to widen the policy focus

The dislocation caused by the pandemic will continue to influence economic outcomes in the new financial year. While rising cases of Covid-19 in different parts of the world suggest that the pandemic still remains a risk, the Indian policy establishment will have to deal with additional challenges over the coming quarters. 

The first big policy test of the new financial year will be the monetary policy review next week. The economic outlook has changed materially since the last meeting of the Monetary Policy Committee (MPC) in February. The MPC will inevitably need to review its inflation projections for the new fiscal year.

While the surge in global commodity prices is likely to push up the inflation rate further, the MPC’s initial projections for the fiscal year were overly optimistic. It expected the inflation rate to decline to an average of 4.5 per cent in 2022-23, compared to 5.3 per cent in 2021-22. The consumer price index (CPI)-based inflation rate has been running above the upper end of the tolerance band. Projections by some private-sector economists suggest the average rate would be over 6 per cent during the year. Also, the rate based on the wholesale prices has been in double digits for 11 consecutive months. As things stand today, even if geopolitical tensions ease a bit in the coming days and weeks, sanctions on Russia are unlikely to go away anytime soon, which would keep commodity prices elevated in the near-to-medium term. A surge in Covid cases in China and other countries would also affect supply chains and push up prices.

Therefore, while the MPC will need to significantly revise its inflation forecast, and also review its policy stance, the Reserve Bank of India (RBI) will need to adjust its policy management. Its decision to not increase the reverse repo rate in February surprised many analysts and it appeared that monetary policy management was falling behind the curve. In fact, the disproportionate reduction in the reserve repo rate itself was unwarranted. If market interest rates needed to be brought down, and RBI had valid reasons to do so in 2020, the MPC should have reduced the policy rate as required. By disproportionately cutting the reverse repo rate and making it the operational rate with a massive infusion of liquidity, the RBI made the MPC practically irrelevant. Since both the reverse repo and the marginal standing facility rate were seen to be moving with the policy repo rate, the RBI introduced an avoidable uncertainty in the overall monetary policy framework. If this was done as an emergency measure, it is hard to justify its continuation. Thus, the RBI needs to restore normalcy on this account. 

However, it has done well to absorb part of the excess liquidity through variable-rate reverse repos, which have increased the effective reverse repo rate. Aside from potentially higher inflation, the MPC will also need to consider several other factors. Two years after the emergency rate reduction, the committee needs to deliberate as to how long it can keep the real policy rate in negative territory, and what could be the potential consequences for price and financial stability. Besides, monetary accommodation is being rolled back globally and policy action is likely to be more aggressive than what was expected until a few months ago, particularly in the US.

In terms of policy, the MPC has assured to maintain the accommodative stance for as long as necessary to revive growth on a durable basis. According to its February projections, the Indian economy will expand by 7.8 per cent in 2022-23. As the base effect wanes, the economy is expected to grow at 4.4 per cent in the second half of the year. The global economy is now slowing down and India’s growth projections will need to be adjusted accordingly. Since this is not the desired level of growth, the central bank will need to take a call as to what extent it can support growth and ignore inflation risks. The retail inflation rate has averaged 5.8 per cent over the last 24 months. The MPC would certainly not want to be in a position similar to the US Federal Reserve. A sudden forced change in policy could be more damaging for growth. It is worth noting here that the government is also likely to run a significantly higher deficit in the foreseeable future. Sustained policy accommodation at this level, particularly in the given global economic backdrop, could create risks.

The bigger issue for the Indian economy, however, is that growth is likely to revert to pre-pandemic levels. The challenge, therefore, will be to push up economic growth in a sustainable manner at a time when both the fiscal and monetary policy would be more constrained. Even though the global outlook is uncertain because of a variety of factors, India must reassess its position and target what is achievable in the near term without taking excessive policy risks. But it would need a more robust plan for the medium term to attain higher sustainable growth. This will not be easy, but a broad policy status quo may not increase the potential growth in a sustainable manner.