MPC must fight inflation more aggressively

The MPC in its second scheduled meeting in this fiscal raised the policy repo rate by 50 basis points to 4.90%, which was in line with the median market expectation. The hike comes close on the heels of a 40 basis point hike in the repo rate and 50 basis point rise in CRR announced after a surprise off-cycle meeting held nearly a month ago.    

The yield on the benchmark 10-year remained more or less unchanged at 7.50 per cent after the policy.  The equity market closed lower, after witnessing some volatility.

Inflation and growth forecasts

The MPC has further raised its CPI inflation forecast for 2022-23 from 5.7 per cent announced in its April meeting to 6.7 per cent now. Embedded in the forecast is the expectation that inflation will fall a tad below 6 per cent in the fourth quarter of this fiscal. In other words, the effect of the 90 basis points of tightening so far and further possible hikes in August and thereafter will be felt in early 2023. The MPC has kept unchanged its growth forecast for 2022-23 at 7.2 per cent. 

Supply-side shocks emanating from the Russia-Ukraine war

In the policy statements issued this time and in May as also in the minutes of the May meeting, one comes across a number of references to the humungous supply-side disruption and fuel & food price shocks caused by the on-going war in the Black Sea region as the driver of the spurt in inflation in India. One member of the MPC, acknowledged that such shocks in the past led to second-round effects, but was hopeful that this time would be different on account of a variety of factors, including policy response (on the part of the government). Another member rued that the monetary authorities have no option but to compress demand by raising policy rates that will waylay the post-pandemic recovery and may even lead to stagflation.   

Pre-emptive withdrawal of monetary accommodation done in a calibrated manner entails less harsh rate increases than would be the case with ‘frontloaded’ hikes

The imported inflation hypothesis is not entirely true, though. When retail inflation rose to an 8-year high of 7.79 per cent in April, 2022, a related fact that didn’t catch much attention then was that it was the 31^st month in a row that this headline print exceeded the RBI’s medium-term inflation target of 4 per cent. Moreover, it showed an upward trend with the January-March average at 6.3 per cent. The wholesale inflation rate has been in double digits for over a year now. Quite clearly, inflationary expectations had already become unhinged before the outbreak of the war in the last week of February this year.

The RBI was perhaps aware of this. But its optimism – akin to what underlies a trader’s bet - about a significant lowering of inflation in 2022-23, as reflected in its forward guidance issued at the end of the MPC huddle that month created a sizeable ‘behind the curve’ gap. That gap will now have to be bridged through ‘frontloaded’ rate hikes, as different from pre-emptive rate hikes. For all we know, pre-emptive withdrawal of monetary accommodation done in a calibrated manner entails less harsh rate increases than would be the case with ‘frontloaded’ hikes. Further, the imported inflation is probably not entirely due to supply-chain disruptions caused by the Ukraine conflict. Strong U.S. demand is propelling up spending on goods all over the globe. India’s robust export performance in the recent period provides evidence in this regard.  

As per the latest business inflation expectation survey undertaken by a premier business school of the country, a noticeable cost increase now seems to co-exist with a decent sales expectation. Given this, the undertone of the policy statements that MPC is reluctantly front-loading rate hikes in the face of supply-side shocks emanating from abroad will certainly not enhance its credibility. In the past, the tendency to attribute most price rises to supply-side reasons didn’t help.     

Primacy of price stability and anchored inflationary expectations

It was very timely and apposite for the RBI Governor to state in his concluding remarks ‘that preserving price stability is the best guarantee to ensure lasting growth and prosperity’. A stable price environment and anchored inflationary expectations also constitute the necessary condition for expansion of the production potential frontier of the economy. Under the flexible inflation targeting framework, the RBI’s commitment to keeping inflation and inflationary expectations under check should be unconditional: needless to say, the causes, consequences and treatment would be different, depending upon whether any rise thereof is due to a supply-side push or demand-side pulls or a combination of both. It is perfectly legitimate on the part of the MPC to craft its tightening measures and its forward guidance in such a manner so as to minimise the growth sacrifice that will be involved.

But, to be realistic, there is no magic solution here: for one thing, growth is likely to be lower both in 2022-23 and 2023-24 vis-à-vis forecasts. For another, inflation is not likely to sprint lower. Larger cumulative rate hikes – not less than 200 basis points - will probably be needed to bring retail inflation close to 4% - its medium-term target. But it appears that MPC’s immediate aim is to bring back headline retail inflation less or equal to 6% over the next three quarters to be technically in compliance with its mandate. If this were the case, then, among other things, the real interest rate will continue to be in the negative territory, as has been the case since the start of 2020. This will be a good thing for the cost of government’s borrowing, but the genie of inflation will stay comfortably out of the bottle.

To surmise that creating conditions for the government to borrow at negative real rates over a prolonged period of time will be inflation-neutral will be a mistake, even if a portion of the borrowing is utilised for addressing supply-side issues, including oil-price shocks, as is being done currently.  

(The writer is a former central banker and a consultant to the IMF)