RBI’s decision to keep the policy rate unchanged could pose a serious risk to growth due to a rise in lending rates and higher-cost of loans to industries

The Reserve Bank of India (RBI) six-member Monetary Policy Committee (MPC) on December 8, 2023, decided to keep the policy rate (the interest rate at which the RBI lends to banks) unchanged at 6.5 per cent. 

The MPC has also said that the actions of the RBI will remain "actively disinflationary". The decision is a continuation of a trend wherein the RBI has been overly obsessed with the management of inflation and aggressively used the two prime monetary policy instruments in its armoury namely the policy rate and liquidity (a jargon for the quantum of credit available in the banking system). In this, it has the full backing of the Union Government which in 2016, put in place an institutionalized framework to enable the MPC to formulate monetary policy and determine the key interest rates for inflation targeting. 

It mandated the RBI to fix the policy rate in such a manner as to maintain inflation - as represented by the consumer price index (CPI) - within the target range of 4 per cent (+/- 2 per cent) for five years ending March 31, 2021 (the mandate has since been extended till March 31, 2026). In case of failure to maintain the inflation target for three consecutive quarters, it is required to submit a report to the Government explaining the reasons and spelling out the remedial actions it would be taking to check the price rise.

Maintaining high and inclusive economic growth is also an equally important objective which the RBI concedes. In fact, the statements of the RBI governor after every bi-monthly review of the monetary policy talk about maintaining a balance between the two objectives. But, in practice, it gives disproportionate attention to inflation targeting. The irony is when it comes to outcome even on inflation, it doesn’t get much success. Let us look at some facts.

In December 2018 when the RBI governor Shaktikanta Das took charge, the economy was on the downswing even as GDP growth during the third quarter of FY 2018-19 onwards, was dipping. Then, the policy rate reached a peak of 6.5 per cent, courtesy of a tight stance taken by his predecessor Urjit Patel. Beginning in February 2019, Das went for an aggressive cut in the policy rate which had plummeted to 4 percent by May 2020. Despite the cuts, growth didn’t revive.

During 2019-20, GDP growth reached a historic low of 4 per cent. During 2020-21, it was negative at 6.6 per cent, courtesy of the overpowering effect of the Corona pandemic. During 2021-22, GDP growth rebounded to 8.9 percent. Though one might argue, low-interest rates helped revival, the fact remains that it was primarily the resumption of economic activities - following the lifting of Corona-related restrictions - that made it possible.  

From January 2022 onward, there was a spurt in inflation that continued through most part of FY 2022-23. The spurt prompted the RBI to invoke its pet theme of ‘inflation targeting’. Beginning May 2022, it delivered a cumulative hike of 1.4 per cent in the policy rate during the first half of the FY (in three lots i.e. May/June/August). It continued to deliver more hikes during the second half adding to 1.1 percent (October/December 2022 and February 2023).

A total hike of 2.5 per cent thus restored the rate to its earlier peak of 6.5 per cent by February 2023. Yet, inflation remained stubborn almost throughout 2022-23. This was tacitly admitted by Das in his April 2023 policy statement: “When we started the rate cut cycle in February 2019 to provide support to growth, the CPI inflation was around 2 percent and the policy repo rate was 6.50 percent. Now, the policy rate is 6.50 percent but inflation is 6.4 per cent”.

After February 2023, during the five policy reviews in a row April/June/August/October/December 2023, the RBI has kept the policy rate unchanged at 6.5 per cent. This is despite the CPI inflation decreasing from a high of 7.4 per cent in July 2023 to 5 per cent in September 2023 and 4.8 per cent in October 2023. The RBI inflation forecast for the FY 2023-24 at 5.4 per cent is also lower than the threshold of 6 per cent at the upper end of the target range.

Despite a benign inflation environment, the banking regulator has decided not to lower the policy rate. It has also retained a policy stance focused on “withdrawal of accommodation”. The terminology was coined by Das way back in June 2019 when he talked of an ‘accommodative’ stance pointing towards a cut in policy rate and an increase in credit availability.

Since, June 2022 the RBI has reversed this stance and has stuck to the withdrawal of accommodation to date. Das has coined a new terminology in the December 2023 bi-monthly policy review and now calls it "actively disinflationary". 

The banking regulator doesn’t want to relinquish its tight policy stance as it suspects that CPI inflation could go beyond the upper limit of 6 per cent particularly in view of a spurt in food inflation during the rest of the current FY. Food inflation (which constitutes around 39 per cent of the CPI basket) declined from a high of 11.8 per cent in July 2023 to 6.6 per cent in October 2023. It was a major factor behind the significant decline in the overall CPI inflation.

Now, to argue that because food inflation could go up, the interest rate can’t be reduced is untenable. The spurt in prices of food items has a lot to do with disruption in supplies caused primarily by seasonal factors. For instance, the impact on the wheat crop during Rabi 2021-22 was triggered by unusually high temperatures. During the Rabi 2022-23 season, rains accompanied by hailstorms in some areas had impacted wheat production. The high inflation in July 2023 was due to a spike in prices of vegetables primarily tomatoes and onions – again caused by seasonal factors.    

Such price pressures albeit on the supply side will automatically dissipate once the seasonal factors subside. Besides, government interventions in a variety of ways such as releasing supplies from stocks with its agencies, export ban/other restrictions such as minimum export price (MEP), price stabilization operations etc. can help in checking price rise. The RBI can achieve little either by way of keeping interest rates high or restricting credit availability. Another area where the prices get out of control due to supply disruptions is fuel and fertilizers. The spurt in their prices during 2022-23 was mostly due to disruption in global supply chains caused primarily by the Ukraine War. During the current FY, oil exporters sustained high prices with the decision of the Organization of the Petroleum Exporting Countries (OPEC) in April 2023 to cut output by 1.16 million barrels per day (mbd).

Here also, the RBI intervention vide a tight monetary policy is of little help as it is focused on demand management whereas fundamentally the problem lies at the supply end. While, RBI’s actions offer no guarantee that these would help contain inflation within the prescribed limit, these could pose a serious risk to growth due to a rise in lending rates, an increase in EMIs of millions of borrowers and higher cost loans to industries, especially MSMEs. It should shed its current stance and make way for some cut in the policy rate (at least one per cent) in the next review due in February 2024 and provide adequate liquidity to support growth.

(The writer is a policy analyst, views are personal)