Prima facie, little surprises on board the monetary policy statement announced by the RBI in Feb 2021. This is the last monetary policy not just of the current financial year but of the inflation targeting set five years back. The government will have to review the inflationary thinking and set new targets for the next five years in March 2021. The new inflationary targeting benchmarks will come into effect in the next monetary policy to be announced in April 2021. The RBI’s Monetary Policy Committee (MPC) has decided to retain the benchmark repo rate and the reverse repo rate at the existing rates thus maintaining status quo. This is something of expected given the mandate to retain inflation within the band of 2-6%. The inflationary figures have been above the higher band of 6% for six months before easing a bit in December. The inflation is likely to be around 5.2% in the last quarter of the current financial year. The RBI does not want to reduce interest rates apparently because the inflation might again increase.
There was no doubt, it was testing times for RBI in the past year. The global economy in its assessment continues to be very sluggish. The new strains of the Chinese virus and consequent lockdowns in Europe and even Japan have weakened the global economy. The aggregate demand continues to be weak. The vaccination drives is likely to revive the economic spirits while reducing the risks of pandemic disruption. On the overall, the global economy might continue to be in a contraction zone. The Indian economy is making a sort of revival. The high frequency indicators are showing an increase. These include the rail freight, e-toll collection, and demand for steel among other things. The purchasing manager’s index is above 50 indicating a positive expansion. The pandemic seems to be quite well contained for now in India. All these indicate a ground for positive optimism from the economic perspective as India heads into 2021. As RBI shapes its monetary contours, there would be questions on its stance.
In theory, RBI’s stance is something correct. There is no doubt, that RBI is fulfilling its mandate as entrusted to it. Yet, in times of abnormality pervading the global economy, the conventional monetary tools might themselves hitting a limit. The interest rates as source of inducing investment and consumption is something not going to work in these disruptive times. There are questions around the efficacy of inflation targeting. Inflation has to be targeted, yet there is a growth element that has to be sacrificed for curbing each unit of inflation. While it would tolerated in the normal scenario, in the current scenario, growth becomes a priority. As long as the growth remains above the real rates, it would make sense if one allows for greater tolerance of inflation. At higher levels of growth, inflation would perhaps contain itself.
The core elements of inflation continue to remain elevated. The deflation in vegetable prices apparently has eased the inflationary trends. The food prices are experiencing a slow decline. The kharif harvest is expected to be good and thus will ease the supply side concerns on matters of food and non-food crops. RBI is projecting a need to disinflate the economy. the inflationary tendencies that emerged has to do with the supply side disruption notwithstanding the demand side disruptions. The cost-push inflation would perhaps run itself out as the vaccination drives intensify and the pandemic induced by the Chinese virus would retreat. The global economic recovery too would result in increase in exports thus helping aggregate demand. Yet, as one goes along, the current priority has to be growth. The economy whose equilibrium shifted downwards when both AS and AD shifted downwards artificially. Both AD and AS need to come back to their upward trajectories and shift rightwards in geometric terms. This would mean some tolerance of inflation in the short run. The higher fiscal deficit would need interest rates to be lower to allow for future deficit control. Given the rate of economic growth to hit double digits, substantially due to lower base effect, the interest rates being lower would benefit the economy. Therefore, the RBI’s policy of keeping the rates constant is something deemed to be conservative.
Investment is inversely proportional to real interest rates. At this moment, real growth is negative. The nominal growth rate is less than the interest rates. If growth is less than the cost of capital, there would be concerns in terms of fiscal health. Therefore, the interest rates must come down until the nominal rates pick up. the real interest rates must lie around 1-1.5% something that is happening with inflation as measured by CPI coming down. In terms of WPI, there is a slight negative real interest rates. The negative real rates should spur investment. However investment in the current era would be contingent on autonomous factors unlike induced factors in normal times. This is the reason why the government is stepping in to create AD and thus the spill-over effect of investment creation. Historical evidence from Europe in the post pandemic ages of the past have pointed to lower interest rates for very long period of time. Globally, one might witness the same in the current situation for fairly long period of time. Unless the employment returns to normalcy, consumption is likely to remain relatively muted.
Thus there were reasons more than one, the Reserve Bank should have shed its apprehensions and conservativeness and gone for bolder policy. There might have been a case for small reduction in repo albeit symbolically to illustrate its priorities for growth. With inflation within the band of the target, there was some case for reduction. The fuel prices are on a direction northward, yet these are primarily due to the taxes and the need for the government to increase its tax revenues. The shift upwards is likely to be in the short run before a decline is visible. There is also an element of discouragement of non-essential travel in the pandemic period. The Central Bank has to be fortright in setting priorities for growth than sticking to text book. The growth projection in double digits for the forthcoming financial year. The monetary multiplier would be a catalyst if the interest rates continue to remain low. There is of course a possibility of negative real rates in WPI terms, yet the real rates are measured in CPI terms since this is the benchmark for inflation targeting. Yet, while RBI has maintained an accommodative stance, it has chosen to play safe. The challenge now of course is to revisit the efficacy of inflation targeting at least in the next few years given the priority is to see the growth coming back into the Indian economy.
Thoughts on Theory and Practice 