Optimal policy position

MPC should focus on inflation management

The headline inflation rate for June increased to a four-month high of 5.08 per cent as against 4.8 per cent in the previous month. The rate is well above the Reserve Bank of India’s (RBI’s) inflation target of 4 per cent. However, there is a view in the market that since the core inflation rate, which does not account for more volatile components like food and fuel, has drifted to about 3 per cent, there is a case for the Monetary Policy Committee (MPC) to reduce the policy repo rate. The headline rate is being driven primarily by food prices, largely because of supply-side issues, and monetary policy has limited impact in such conditions. The food inflation rate in June was above 9 per cent. While there are strong reasons why the MPC should not be in a hurry, new research strengthens the MPC’s majority position on the policy rate.
 

A research article featured in the latest monthly bulletin of the RBI — though it doesn’t reflect the official position of the central bank — showed the estimate of the natural rate of interest for the fourth quarter of 2023-24 was 1.4-1.9 per cent. Notably, the latest estimate is significantly higher than the previous estimate of 0.8-1 per cent for the third quarter of 2021-22. The natural rate can be defined as the level of the interest rate where savings equal investment with stable prices. In terms of monetary-policy operations, the difference between the real policy rate and the natural rate of interest reflects the stance of the policy, or whether the policy is restrictive or accommodative. If the real policy rate is higher than the natural rate, the monetary policy is restrictive and vice versa. The research article also notes the estimate for the natural rate of interest in India has shown an upward movement in the post-pandemic period, largely because of strong growth in potential output.
 

Given that the MPC expects the headline inflation rate to average 4.5 per cent this financial year, the policy repo rate at 6.5 per cent can be seen as neutral, considering the upper end of the range for the natural rate of interest. Even at the lower end, the policy rate can be lowered by 50 basis points at best. However, it is worth highlighting that estimating the natural rate of interest in India is not easy because of ongoing structural changes. It may thus be safer for the MPC to consider the upper end of the band — also because the natural rate is increasing.
 

Given the economy’s investment needs, India needs higher savings, which may be affected by excessive policy accommodation. It is also worth highlighting that banks are witnessing much higher growth in credit than in deposits, forcing them to raise funds from the market. As RBI Governor Shaktikanta Das rightly noted in his remarks last week, this could expose the banking system to structural liquidity issues. A premature reduction in the policy rate could further exacerbate this phenomenon. Considering all issues, it makes sense for the MPC to wait for the inflation rate to settle comfortably near the 4 per cent target. Since India is growing at a healthy pace and research shows that potential has improved, it gives the RBI the necessary policy space to focus on inflation management.