RBI admits it will miss inflation target, but remains overly optimistic on growth

This increase was widely expected as it came on the back of the US Federal Reserve, the American central bank, raising its key short-term interest rate, the federal funds rate by 75 basis points to 3-3.25%. Federal funds rate is the interest rate at which commercial banks in the US lend their excess reserves to each other on an overnight basis. Given that the US Fed drives the direction of global monetary policy, it doesn’t make sense for any other central bank to fight the Fed. The RBI is no exception to this rule.

Further, the interest rates in the Indian economy have been rising anyway, due to reasons beyond the RBI raising the repo rate. First, the RBI has been trying to defend the value of the rupee against the dollar. It does so by selling dollars from its reserves and buying rupees. Up until recently, there was a lot of money floating around in the financial system, which banks had no use for. Hence, when the RBI sold dollars, it pulled out this excess liquidity. This along with increased lending by banks (as we shall see) has ensured that the excess liquidity has now more or less come to an end.

Second, the lending by banks has picked up pace. As of 9 September, the year-on-year non-food credit growth had stood at 15.5%. This is the fastest the credit growth has been since September 2014. Banks lend to the Food Corporation of India (FCI) and other state procurement agencies to help them buy rice and wheat directly from farmers. This lending is referred to as food credit. When this lending is subtracted from the overall bank lending, what remains is non-food credit.

In comparison, as of 9 September, the year-on-year growth in deposits had stood at 9.5%, implying a considerable gap between credit growth and deposit growth. This gap, along with the end of excess liquidity in the financial system, has been pushing up the interest rates on deposits and in the process on loans as well. The demand for money has gone up. The supply hasn’t. Hence, interest rates are going up and will continue to go up.

The hope is that this rise in interest rates will help rein in inflation, at least the consumer-demand driven part of it. The RBI’s inflation forecast for 2022-23 stays unchanged at 6.7%, with the inflation in the second half of the year expected to be lower than that in the first.

As per its agreement with the government, the RBI needs to maintain the inflation as measured by the consumer price index (CPI), or retail inflation, at 4%, with a band of +/− 2%. This means that the upper tolerance level of inflation is 6%. RBI is deemed to have failed to meet the inflation target if retail inflation stays above 6% for three consecutive quarters.

As the latest monetary policy statement put it: “Inflation is likely to be above the upper tolerance level of 6 per cent through the first three quarters of 2022-23." This means that the RBI is likely to fail to meet its mandate during this year and it is admitting to the same.

What makes the situation worse is that core inflation (after leaving out food and fuel items) remains elevated. In August it was at just above 6%. As the monetary policy statement put it: “Core… inflation remained sticky at heightened levels, with upside pressures across various constituent goods and services." This means that inflation is not just being driven by high food and fuel prices and it has become systemic.

The situation is unlikely to get easier in the time to come with the war in Ukraine dragging on. Further, the Fed and other rich-world central banks are trying to tackle decadal high inflation. They have two tools in their kitty to do that. First, is increasing their key-short term interest rate, like the federal funds rate in case of the Fed. Second, is to gradually take out all the money they have printed and pumped into the financial system over the years. This will push up interest rates probably leading to a recession or a huge economic slowdown across the rich world. As Jerome Powell, the Chairman of the US Federal Reserve, recently said: “I think that there’s a very high likelihood that we’ll have a period… [of] much lower growth... So the median forecast now I think this year among my colleagues and me, was 0.2% growth. So that’s very slow growth." More and more economists are predicting a recession in Europe as well.

This is definitely going to impact economic growth in India as well, by dragging down exports growth, for one. Taking these factors into account the RBI cut the economic growth forecast for 2022-23 to 7%, with the growth in the second-half of the year expected to be slower than the first-half.

The RBI had earlier projected a growth of 7.2% in 2022-23. The way things are currently going, it might turn out that the RBI is being more optimistic than it should be. The optimism could be seen in Governor Shaktikanta Das’ address, which ended with the following statement: “Today, despite the gathering clouds over the global economy, the Indian economy inspires optimism and confidence."