Why India’s monetary policy is still effective, in 5 charts



The RBI started tightening policy in May 2022, and inflation came within range in November. In contrast, in the rich world, especially in the US and UK, ordinary people are still bearing the brunt of high prices while also facing higher interest rates

New Delhi: India’s monetary policy committee (MPC) is meeting this week in an unusually tough environment. Keeping aside the usual inflation-growth tightrope, some policymakers are questioning the very effectiveness of monetary policy, whose basic tenets have been undermined by decades of globalization. Synchronized interest rate hikes by central banks have failed to tame inflation; rather, they have brought some countries to the brink of recession. But India’s story is different. Its monetary policy still clicks.

In 2016, the Reserve Bank of India (RBI) was asked to maintain retail inflation at 4%, give or take 2%. Until 2020, it was doing a great job. First the pandemic, and then the Ukraine war, disrupted the economy through multiple channels. The RBI started tightening policy in May 2022, and inflation came within range in November. In contrast, in the rich world, especially in the US and UK, ordinary people are still bearing the brunt of high prices while also facing higher interest rates.

But the RBI’s task may not be done yet. The inflation momentum—or month-on-month price changes—has started slowing, but two months do not make a trend. The pullback was mainly due to a seasonal drop in vegetable prices, rather than a generalized price decline. By December 2022, items with 81% weight in the consumer price index (CPI) basket had inflation above 4%, and 51% had inflation over 6%—most being items of daily consumption. In other words, headline inflation has come down, but the cost of living has not. What the RBI does will be known on Wednesday.

A Matter of Faith

Monetary policy targets not only actual inflation, but also expected inflation, because it influences current spending choices. The RBI seems to have handled expectations well: Inflation expectations of households and businesses dropped towards the end of 2022.


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In general, households estimate future inflation based on recent price changes in daily-use items. In May 2022, excise duty cuts lowered fuel prices, resulting in a swift drop in inflation expectations in the next household survey round (July 2022), despite actual inflation ruling at 7%-plus levels.

Despite this recency bias, households have weathered three years of relatively high and volatile prices with their expectations reasonably anchored (though much higher than actual inflation). This reflects faith in the RBI. The central bank’s hard-won credibility gives it the space to tighten policy without unanchoring expectations.

Pulls and Pressures

The link between monetary policy and inflation depends on two key relationships. First, a rate hike dampens GDP growth. Next, as economic growth falls below its potential, joblessness rises and wages fall, resulting in lower inflation—a link known as the “Phillips curve". Studies show this link has weakened for advanced countries in the last decade. But not for India, especially in 2022, shows recent RBI research. That is, rate moves are still able to manage inflation.


To get a view of past policy periods, we plot both inflation and GDP growth relative to the 6% mark—a policy trigger level that is the inflation ceiling and also an approximate potential growth rate. The chart shows that the RBI has, in general, adopted the prescribed monetary stance for each situation successfully. The post-pandemic rise in protectionism and deglobalization is likely to strengthen the link between output and inflation, and make it easier to impact both via monetary policy actions.

Homegrown Inflation

Inflation becomes “global" in many ways. As the contribution of exports to GDP rises, global growth affects domestic GDP more. A slowdown in partner countries can reduce export revenues, hurting output, and, therefore, wages and inflation. Inflation can also come via imports, but that may simply be due to currency depreciation.


About a third of CPI inflation comprises imported inflation; but it is not large enough to attribute all our inflation to external causes. For instance, the 2022 inflation build-up began with a rise in prices of edible oil and cereals (of which Ukraine was a leading supplier); then bad weather led to a rise in prices of wheat, vegetables, and paddy grown domestically. India does experience globalized inflation, but not as much as advanced economies. There is much that can still be fixed domestically through monetary policy.

(Deepa Vasudevan is an independent writer in economics and finance.)


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