RBI’s commitment to ‘last-mile disinflation’ has prompted a continued tight monetary policy stance, raising questions about its impact on economic growth

On April 5, 2024, announcing the decisions taken by the six-member Monetary Policy Committee (MPC) in its first bi-monthly meeting of the current financial year (FY), Governor Shaktikanta Das observed “The elephant has now gone out for a walk and appears to be returning to the forest. We would like the elephant to return to the forest and remain there on a durable basis,”

Das was using the elephant analogy to characterise the trajectory of retail inflation as represented by the Consumer Price Index (CPI). Having scaled to a high of 7.8 per cent in April 2022, CPI has declined to 5.7 per cent in December 2023 and further down to 5.1 per cent during January/February 2024. He wishes that the downward movement in the CPI will continue and that it will stabilise at the ‘target’ level on a sustainable basis. To put things in perspective, let us look at some basics. 

In 2016, the Union Government put in place an institutionalised 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 (the interest rate at which the RBI lends to banks) in such a manner as to maintain 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. 

The RBI uses the two prime monetary policy instruments namely the policy rate and liquidity (a jargon for the quantum of credit available in the banking system) for management of inflation. It is also committed to maintaining high and inclusive economic growth. But, in practice, it gives disproportionate attention to inflation targeting. Yet, when it comes to the outcome of inflation, it doesn’t get much success. Let us look at some facts.

In December 2018 when 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. Pertinently, inflation remained within the target range during the first three-quarters of that FY despite a low-interest rate.

From January 2022 onward, there was a spurt in inflation that continued through most 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 per cent and the policy repo rate was 6.50 per cent. Now, the policy rate is 6.50 per cent but inflation is 6.4 percent”.

In other words, he accepted that the RBI was unable to bring down inflation even after increasing the policy rate to 6.4 per cent. After February 2023, during the six policy reviews in a row April/June/August/October/December 2023 and February 2024, the RBI kept the policy rate unchanged at 6.5 per cent.

This was despite the CPI inflation decreasing from a high of 7.4 per cent in July 2023 to 5 per cent in September 2023, 4.8 per cent in October 2023 and 5.1 per cent during January/February 2024. For the whole of FY 2023-24, at 5.4 per cent, it was lower than the outer (albeit target) limit of 6 per cent.  

In its April 2024 review, yet again the RBI has kept the policy rate unchanged at 6.5 per cent. This is despite its assessment that the CPI inflation will be 4.5 per cent during FY 2024-25 which is well within the target range of 4 per cent (+/- 2 per cent). Yet, the decision is driven by the central bank’s commitment to what Das describes as ‘ensuring last-mile disinflation’, saying there is no need to start reducing interest rates until inflation reaches the target of 4 per cent. If, that indeed was the intent then why keep (+/- 2 per cent)? 

The RBI 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”.Why doesn’t the RBI want to give up its tight policy stance? Even as Core inflation (CPI excluding fuel and food) at 3.4 per cent continues to be below RBI’s 4 per cent target and fuel prices have remained unchanged throughout the year, its main worry is food inflation. After declining from a high of 11.8 per cent in July 2023 to 6.6 per cent in October 2023, in recent months, it has gone up the most recent reading being 8 per cent.

Too much focus on food inflation is misplaced. First, the current CPI basket gives a weight of around 39 per cent to food. But, that is based on the Consumption Expenditure Survey (CES) of 2011-12. Summary statistics from the 2022-23 CES show that this has fallen significantly. With this correction, the impact of food inflation on CPI will significantly weaken.    

Second, the spurt in prices of food items has a lot to do with disruption in supplies caused primarily by seasonal factors.

During the last two years, wheat output was affected by unusually high temperatures during 2021-22 and rains accompanied by hailstorms in 2022-23. The high inflation in July 2023 was due to a spike in the prices of vegetables - again caused by seasonal factors. Third, RBI can achieve little by increasing the policy rate or restricting credit availability as these measures work primarily on the demand side whereas the problem lies at the supply end. 

Meanwhile, continuing with a tight monetary policy stance 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. While, everyone — like the governor — would wish that the elephant returns to the forest and stays there permanently, the RBI doing it alone could boomerang.  

“Wheat harvesting is by and large over... wheat availability will not be affected as much as it did 2 years ago when heatwave conditions were starting from March. So, in wheat, there is not so much concern.

But vegetable prices will have to be watched and any other impact that heat wave conditions may produce,” Das said at a post-policy press briefing. “As compared to the previous three years, the INR exhibited the lowest volatility in 2023-24. The relative stability of the INR reflects India’s sound macroeconomic fundamentals, financial stability and improvements in the external position,” he said.

The headwinds from protracted geopolitical tensions and increasing disruptions in trade routes, however, pose risks to the outlook, Reserve Bank Governor Shaktikanta Das said. Governor Das added that the outlook for agriculture and rural activity appears bright. Governor Das added that the outlook for agriculture and rural activity appears bright.

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