RBI steers clear of policy adventurism
The Reserve Bank of India has cut its inflation forecast for the financial year, but there are clear upside risks
The monetary policy committee (MPC) that sets Indian policy interest rates did not spring any surprises in its first meeting of the new financial year: It left key policy rates unchanged.
It had good reasons to do so. The Indian central bank has cut its inflation forecast for the financial year that began this week, but there are clear upside risks that the MPC has mentioned. Also, the committee had clearly noted in its February meeting that the ongoing nascent recovery in the Indian economy needs to be nurtured through stable macro-financial management. Further, not much clarity has emerged on the risks that the MPC had highlighted in the previous policy—it reiterated some of those risks in its latest statement, even as it lowered the inflation forecast for the current financial year. It now expects inflation, based on consumer price index, to be in the rage of 4.7-5.1% in the first half of the fiscal and come down to 4.4% in the second half—including the effect of house rent allowance for Central government employees under the seventh pay commission—with risks on the upside.
Oil prices continue to remain volatile and elevated. There is not much clarity on how the higher minimum support price (MSP) and related policies, announced in the Union budget, will be implemented. However, it has been reported that an increase in MSPs, and ensuring these for farmers, could push up farm gate prices by about 15%. This could have a significant impact on retail food inflation. Further, there is a risk of fiscal slippage at both the Central and state levels. Also, if the monsoon turns out to be deficient, it will have consequences for both inflation and government expenditure.
On the growth front, the MPC has revised its gross domestic product (GDP) growth forecast to 7.4% in the current fiscal from 6.6% in the last fiscal. A pick-up in bank credit and resource mobilization from the market should help push investment activity. The upward revision in GDP growth forecast and downward revision in the inflation forecast show that India will have more favourable economic conditions in the current financial year. This should please both policymakers and financial markets. Both the stock and bond markets reacted positively to the policy statement. While the stock market has been volatile in the recent past, bond yields have come down after the government lowered its market borrowing target and decided not to front-load bond issuance in the first half of the financial year. The RBI also did its bit by allowing banks to spread provisioning on account of mark-to-market losses.
However, there are risks to this favourable economic outlook. As noted earlier, a substantial increase in MSPs could push inflation and affect inflationary expectations, forcing the MPC to raise policy rates. Possible fiscal slippage could push the cost of money in the financial market, affecting investments and growth. Further, volatility in the global financial markets on account of faster than expected tightening of monetary policy in the US or growing tensions in trade relations can affect capital flows, which could worsen the overall investment climate. It will be crucial to watch capital flows as the current account deficit is expected to widen this year. While India has sufficient reserves to effectively handle possible volatility in the currency market, policymakers would do well to remain vigilant on this front.
Although there are risks to both inflation and growth projections, as things stand today, the MPC is unlikely to change its position in the foreseeable future. At a broader level, this is also supported by the way inflation and inflationary expectations have evolved after the adoption of the inflation-targeting framework by the RBI.
In a recent paper published in the Economic And Political Weekly, Ravindra Dholakia of the Indian Institute of Management, Ahmedabad, and Virinchi Kadiyala of ICICI Bank showed that inflation has come down significantly after the adoption of the inflation-targeting framework and has helped anchor inflationary expectations in the economy. As a result, a shock to core inflation is likely to fizzle out faster than before. What this essentially means is that with well-anchored inflationary expectations, financial markets can expect a more stable monetary policy, which will not necessarily respond to every supply-side shock to headline inflation in the short run. This will provide a more stable macroeconomic environment, which will help push up investment and growth in the medium to long term.
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