In recent weeks, there has been intense debate over the RBI’s monetary policy stance and its money market interventions.
It has been felt that the central bank is more concerned about inflation and less about the growth rate in the direction of monetary policy. And this has led to keeping interest rates more restrictive than necessary. This view has been expressed not only by former members of the Monetary Policy Committee, but also recently by the government, a section of the market and some analysts.
Earlier in February, when the central bank projected inflation at 4.5 percent for 2024-25, MPC member Jayanth Verma voted in favor of a rate cut. Verma had argued that keeping inflation projections in mind, such a high real rate was not necessary to bring inflation to the target of 4 percent. At the June policy meeting, Verma joined Ashima Goyal, who argued that even after a rate cut of 25 basis points, “monetary policy will remain disruptive towards bringing inflation to target credibly”.
The central bank’s comments suggest it is uncertain about the pace of food prices, and is concerned about food inflation spilling over into core inflation. Recent data showed inflation rose to 6.21 per cent in October from 3.65 per cent in August – seemingly confirming the RBI’s fears.
However, it has been argued that these concerns do not hold for several reasons. First, the increase in inflation is mainly due to vegetables, which rose by 36 percent in September and 42 percent in October. Excluding vegetables, inflation was 3.3 percent in September and 3.6 percent in October. Second, there is little evidence of price pressures in the broader economy. The labor market is weak, and wage growth is slow. Core inflation remains muted. According to this paper’s report (IE, December 1, ‘Amid recession, RBI-govt gulf widens, hikes holding rates’), even government officials have questioned the RBI’s views on price pressures in the economy. Third, what matters for monetary policy is that inflation is a few quarters below the line. And those expectations haven’t changed significantly. In October, the central bank estimated that inflation would be 4.3 percent in the first quarter of the next financial year. While it has now revised its forecast slightly higher to 4.6 percent in the first quarter, it expects growth to be in line with its target of 4 percent in the second quarter.
On a forward-looking basis, these estimates imply a real interest rate of 2.5 percent. By comparison, Verma had earlier argued that “a real interest rate of 1-1.5 percent would be sufficient to drive inflation to the 4 percent target.” As inflation moves toward the target, policy should become less restrictive. An overly tight policy will lead to higher growth sacrifices.
According to the RBI’s commentary, this was a “flexible” hike that provided room for the Monetary Policy Committee to “focus more clearly on inflation”. This justification was provided even as the underlying economic momentum was slowing, with several indicators pointing in that direction, including core inflation. Editorial in this paper (IE, October 26, ‘Shrink pocket‘) also pointed out that comments from sections of India Inc. were also indicating a slowdown in household demand.
The RBI’s rather liberal views on growth were also in direct contrast to the government’s. As this paper reports (IE, December 1, ‘Amid slowdown, RBI-govt gulf widens, hikes in holding rates‘), government officials questioned the central bank’s growth projections in June. The Ministry of Finance’s August and September monthly reviews also spoke of the pain points of the economy.
Second quarter GDP estimates have confirmed these fears. However, even though the RBI has revised downwards its GDP forecast for the year, the central bank sees the slowdown as temporary in nature. It expects the economy to bounce back strongly. However, nothing is certain. It seems that the central bank is very concerned about inflation, and complacent about growth.
Then there is the matter of currency. The election of Donald Trump has injected a degree of uncertainty into the global environment. Markets are grappling with the possibility that Trump will raise tariffs, which will be inflationary, and cut taxes, which will increase the deficit. This means the US Federal Reserve may not be able to cut interest rates to the extent previously anticipated. Put differently, interest rates will be higher than previously expected. This will strengthen the dollar.
October and November also witnessed a large outflow of foreign investors from the Indian market. Foreign investors pulled out $13.6 billion in the two-month period (its net investment was negative), some of which was due to a rebalancing of global portfolios in favor of China. All this has put the currency under enormous pressure as an article in this paper points out (IE, November 19, ‘RBI’s blind spot‘)
During this period, the scale of central bank intervention in the currency market to protect the rupee was truly astounding. Between September 27 and November 22, RBI’s foreign exchange reserves fell by $48 billion. While some of this may be due to the revaluation of reserves, the decline gives some indication of the extent of central bank intervention. Foreign investors have withdrawn in the first week of December, net investment is 2.8 billion dollars, but the pressure on the currency remains. At the December MPC meeting, RBI Governor Shaktikanta Das mounted a strong defense of the central bank’s currency intervention. He argued that the interventions were meant to ease “excessive and disruptive volatility”, and not target a fixed exchange rate level. But interest rate cuts can lead to capital outflows and weaken the currency.
The next meeting of RBI’s Monetary Policy Committee is scheduled to be held on February 5-7. As an editorial in this paper (IE, December 7, ‘Inflation at the center‘) pointed out that, by then, there will likely be greater clarity on the country’s growth-inflation dynamics, fiscal policy stance, and Trump’s tariff policy. This could potentially create conditions for the central bank to ease policy rates.
until next week,
Ishan Bakshi