The last mile

Climate issues can complicate monetary policy

The outcome of the Reserve Bank of India’s (RBI’s) first Monetary Policy Committee (MPC) meeting of the financial year did not surprise anyone. Nevertheless, the tone of the RBI governor’s statement, the monetary policy resolution, and the post-policy media interaction by RBI officials suggested that the MPC was determined to achieve the legally mandated target of 4 per cent inflation rate on a durable basis, which must be welcomed. As a result, the MPC left the policy repo rate unchanged at 6.5 per cent for the seventh consecutive time. Given that the MPC expects the Indian economy to grow 7 per cent this financial year, marking the fourth consecutive year of at least 7 per cent growth, it provides significant policy space to the central bank to focus on inflation and allow the disinflation process to be completed.

While both growth and inflation outcomes have become relatively favourable, and the significance of attaining the 4 per cent inflation target on a durable basis is well understood by market participants, it is worth assessing when the target is likely to be achieved. The MPC expects the inflation rate to average 4.5 per cent this financial year, but that will still be above target. It has been argued, including in the MPC, that the real policy rate of 2 per cent can undermine growth outcomes. But the other view in the committee is that the real policy rate should be seen with the inflation rate, which is projected to remain above target in 2024-25. So, for how long will the MPC maintain the policy repo rate at 6.5 per cent? The Monetary Policy Report (MPR), also released last week, had some interesting indications. It noted that assuming a normal monsoon and no policy shocks, the structural model indicates that the inflation rate will average 4.1 per cent in 2025-26. Projections by professional forecasters polled by the RBI suggest that the policy rate would be reduced by 50 basis points in the current financial year.

Given the comfort on the growth side, it is likely that the MPC will want to be fully convinced that inflation will remain close to the target on a durable basis before contemplating monetary easing. Last-mile disinflation may be testing for both the RBI and financial markets. Notably, the last-mile difficulty in attaining the inflation target is primarily emanating from volatility in food prices. In February, for instance, the food inflation rate was 7.8 per cent, and it contributed about 70 per cent to the headline rate. The core inflation rate, on the other hand, at 3.4 per cent, marked the lowest level in the current series. Food price volatility is always hard to predict, particularly in the context of increasing extreme weather events. In fact, handling food price volatility could become more difficult in the future.

Research featured in the MPR notes that both inflation and its volatility could increase over time. Frequent weather shocks might demand tighter monetary policy. Further, inflation expectations may get de-anchored, undermining the credibility of the central bank. Predictably, this would warrant a higher policy interest rate to contain inflation, which will affect output. How the climate issue and food economy are managed, therefore, can have a significant impact on monetary policy in the medium to long run. For now, the focus will be on rabi output and monsoon prospects.