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Between the scars of the pandemic and the challenges from the Russia-Ukraine war, our economic context is a policymaker’s nightmare. Two years on, economic activity is barely at pre-pandemic levels. Within this, larger firms have done well with increased formalization, even as small businesses have struggled. While contact-based services should now resume, the global backdrop continues to cloud our recovery.

Despite anaemic growth, the consumer price index (CPI) has averaged 6% over two years, and inflation expectations are in double-digits. Considering commodity prices and disrupted supply chains, the CPI could well exceed 6% in FY23.

On employment, notwithstanding shortages in skilled labour, the Centre for Monitoring Indian Economy (CMIE) suggests that India lost 20 million jobs over the last five years.

There are some silver linings in our fiscal and external balance. While fiscal deficits remain high, tax collections are set to exceed targets. Likewise, while crude oil prices could push FY23 current account deficit to over $100 billion, the Reserve Bank of India’s (RBI’s) foreign exchange buffers offers us comfort for now.

As the last two decades have demonstrated, macroeconomics is complicated. There are dynamic inter-relationships between growth, employment, inflation, fiscal balance, external balance, and financial stability. Each of these are in turn impacted by interest rates (the short-end, the long-end, and everything in between), banking liquidity, fiscal choices, exchange rates, macroprudential regulations, RBI interventions, and sentiments. We feared that acknowledging these complications could allow the government of the day to arm-twist policymakers to deliver whatever they wanted, taking refuge under this complexity.

To address this, the RBI Act was amended to introduce a monetary policy committee (MPC), now charged with keeping the CPI between 2% and 6%, by setting the policy (repo) rate.

The setting up of MPC is laudable, as is its clear mandate to control inflation. However, the law also wishes away complexity, by simplistically implying that changes to the policy repo rate alone can bound India’s CPI. Mainstream dogma now suggests that if inflation is up, repo rate must be increased—and anyone suggesting a more nuanced analysis is a heretic.

How should monetary policy now control inflation? Over a two-year period, credit growth is barely at 7.5% per annum, lower than nominal gross domestic product (GDP) growth, while credit to deposit ratio is at just 54%. There is little to suggest, yet, that low short-end rates are feeding inflation via credit growth. In fact, more money has been created by fiscal deficits and foreign exchange inflows, than by credit growth.

However, the possible indirect impact of repressed interest rates on asset prices and inflation cannot be denied. Against three-month ahead household inflation expectations of 11.1%, weighted average fixed deposit rates are at 5%. Given large negative real interest rates, savers are forced into riskier asset classes. Mutual funds saw a record 4 trillion inflows into risk-seeking schemes in FY22, nearly thrice the 1.4 trillion equity outflows from foreign investors. This also explains the resilience of our markets. Similarly, we saw record $50 billion of net gold and jewellery imports in 2021, and a spike in demand for luxury items. Finally, there is also sentiment. In the February policy, MPC had projected average FY23 CPI inflation at 4.5%, much lower than analyst estimates. To manage both inflation expectations and foreign investor sentiment, it is important to preserve policy credibility.

In this backdrop, RBI and MPC deserve credit for their announcements last week. By placing inflation before growth, and by raising FY23 CPI estimates to 5.7%, MPC has strengthened policy credibility. Separately, notwithstanding arguments around public good, 10-year GOI bond yields have been allowed up from 6% last year to over 7% now. Higher returns for long-term savers can help address rising inequity and inflation. At the same time, RBI and MPC will hopefully refrain from rushing in to raise short-term rates, until signs of excessive credit growth emerge. Much of our investment-oriented loans (including mortgage), much-needed for jobs and output growth, are still linked to short-term rates. Hopefully, RBI will continue to shun dogmas, while preserving credibility.

While we spend immense time debating monetary policy, it is the real economy that ultimately matters. China did not become a powerhouse because of its monetary policy framework, but created enough jobs, output, and exports to make monetary policy redundant. We would be well advised to do the same.

Ananth Narayan is an associate professor at S.P. Jain Institute of Management and Research.

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