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Reserve Bank governor Shaktikanta Das.bloomberg
Reserve Bank governor Shaktikanta Das.bloomberg

RBI may need a more hawkish eye on inflation

It held its policy at 4% rate, as expected, and enhanced special credit coverage for stressed sectors, but its dilemma over excess liquidity looks far from resolved

It’s a tight spot the Reserve Bank of India (RBI) is in. Even though our economy slumped into a recession in the first half of 2020-21, there seems little further it can do with monetary policy to spur growth. On Friday, Governor Shaktikanta Das declared that RBI expects national output to contract by 7.5% this fiscal year, revising its outlook for the better. Expansion, in its assessment, is already underway this quarter. Its monetary decision to leave its main policy rate unchanged at 4%, the rate at which it lends money to banks, thus seems appropriate. This is because retail inflation has hovered above its 6% upper tolerance limit for much of this year, the first time its 2016-adopted price-stability framework looks poised for failure. Of course, our covid circumstances constrained it to err on the side of a growth revival. By its latest forecast, RBI expects inflation to drop from 6.8% in the current quarter to 5.8% in the next, and then stay under control. Meanwhile, it has announced wider coverage of an earlier scheme by which banks buy bonds issued by firms in specific stressed sectors--a way to ease credit.

Beyond credit easing to relieve covid distress, supply-side measures have their limits of efficacy, with aggregate demand observed to be in a bad way and investments restrained by uncertainty, and so its focus had to shift to the inflationary effects of excess liquidity detected in the economy. Oddly, this doesn't seem to have happened. With over 6 trillion still being parked daily by banks with RBI at its reverse repo window, a reflection of poor credit demand, analysts had expected something of a mop-up. Plus, India has seen large inward gushes of dollars. To keep the rupee's global value stable and Indian exports competitive, it has been buying those dollars, thus raising our foreign exchange reserves and pumping more liquidity into the domestic arena. Sterilizing the inflationary effect of this usually requires bonds to be sold, which increases their market supply and pressures yields up--a dilution of its stance on easy money. This poses a dilemma that RBI may soon have to grapple with.

RBI made a few regulatory announcements, too, some of them to do with credit derivatives and efforts being made to ensure banking security. But its core task as a central bank, of watching both the external and internal stability of the currency under its charge, may get more complex than ever if capital inflows stay high, global investors see an opportunity in 'carry trade' profits, and price trends don't go by its expectations. Perhaps it will refine its liquidity management by and by. Currency stability, after all, serves as a foundation for an economy's growth, which was why we decided to cap inflation in the first place. If India's broad policy frame is being pushed by our covid crisis towards a major reset, with the Centre's fisc granted a freer run and its debt burden to be partially inflated away over the years, then that would call for another debate.


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