Concerns over persistent food price volatility and the need for economic growth support have prompted the Reserve Bank of India to keep its options open

On October 9, 2024, the Reserve Bank of India (RBI) Governor Shaktikanta Das announced the decisions taken by the six-member Monetary Policy Committee (MPC) in its fourth bi-monthly meeting of the current financial year (FY). It has kept the policy rate (the interest rate at which the RBI lends to banks) unchanged at 6.5 per cent. However, it has altered its policy stance from “withdrawal of accommodation” to a neutral stance. 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 including the policy rate for inflation targeting. It mandated the RBI to fix the policy rate in such a manner as to maintain the Consumer Price Index or CPI (it corresponds to a basket that includes food, fuel, manufactured goods and select services) within the target range of 4 per cent (+/- 2 per cent). The RBI decides the policy rates once in two months during each FY.  

The mandate initially given for five years ending March 31, 2021, has since been extended till March 31, 2026.  The other crucial policy instrument the banking regulator uses for targeting inflation is Liquidity - a jargon for the quantum of credit available in the banking system. Pumping more liquidity along with a reduction in the policy rate represents a scenario which in jargon is described as an ‘accommodative’ policy stance. The terminology was coined by Das in June 2019 when he started going for aggressive cuts in the policy rate and an increase in credit availability. Since June 2022 the RBI changed its stance to “withdrawal of accommodation” and has since stuck to it till date.

From October 9, 2024, it has decided to go for what it terms a “neutral” stance. A “neutral” stance connotes that the RBI has vowed to keep its options flexible meaning it will neither squeeze liquidity by restricting credit availability and keeping policy rates high nor go for unrestrained lending at low interest rates. 

At the time of taking charge in December 2018, Das was confronted with a legacy of policy rate at a peak of 6.5 per cent, courtesy of a tight stance taken by his predecessor Urjit Patel. In February 2019, he initiated a process of aggressive cut that led to its plummeting to a low of 4 per cent by May 2020. It stayed at that level for over two years. Beginning May 2022, the RBI delivered a hike of 1.4 per cent during the first half of FY 2022-23 and another dose of 1.1 per cent during the second half.

A total hike of 2.5 per cent thus restored the policy rate to its earlier peak of 6.5 per cent by February 2023. Since then, the rate has remained unchanged to date.

Why hasn’t RBI reduced the rate? Look at the trajectory of the CPI inflation. It had scaled to a high of 7.8 per cent in April 2022. During FY 2022-23, it hovered around 8 per cent. In the following FY, it started decreasing from 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, it was 5.4 percent. During the current FY also, the CPI inflation has kept low; 5.08 percent in June 2024 and 3.54 percent in July of 2024. During FY 2024-25, the RBI expects the CPI inflation to be 4.5 per cent. Given the above, from the third quarter of FY 2023-24, the CPI inflation has remained well within the target range of 4 per cent (+/- 2 per cent). Moreover, as per RBI’s assessment, this position will be sustained till the end of the current FY.

There was thus a strong case for reducing the repo rate. This would have given a boost to economic growth besides helping millions of borrowers reduce their EMIs and helping industries, especially MSMEs (micro, small and medium enterprises) reduce the cost of servicing their loans.  Yet, the RBI remains unfazed and has stuck to its stance of ‘not reducing the policy rate’. This has to do with a mindset that was reflected in Das’s observation while announcing the first bi-monthly policy of the current FY. He had said “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.” Put simply, he meant there was no need to start reducing interest rates until inflation reached the target of 4 per cent and stayed at that level. If, that figure of 4 per cent was so sacrosanct, then why keep (+/- 2 per cent)?

The short point is the RBI is clamoring for a scenario that is unlikely and even if it is reached, it won’t be possible to stay there for long. A potent reason for this is food inflation which has a weight of around 40 per cent in the overall CPI and is impacted predominantly by supply side/seasonal factors whereas monetary policy instruments work on the demand side.

Invariably, food inflation maintains an upward trend even as a small disruption in supply caused by seasonal factors can lead to spiralling prices. This, in turn, lifts the CPI inflation more so because of its high weight of 40 per cent. In July 2023, food inflation was 11.8 percent which led to CPI inflation of 7.4 percent. In October 2023, the former decreased to 6.6 per cent, and so did the latter to 4.8 per cent. At the start of the current year, food inflation spurted to around 8 per cent and by June 2024, it had further moved up to 9.4 per cent.

As long as food (whose prices are fundamentally affected by supply-side factors) remains a part of the CPI basket, inflation targeting will always remain a problem. There is an urgent need to exclude it while setting benchmark interest rates, an idea that was mooted by the Chief Economic Advisor in the Economic Survey (ES) for 2023-24. The CEA argued that monetary policy has no bearing on the prices of food items, which are dictated by supply-side pressures. For instance, during 2021-22, wheat output was affected by unusually high temperatures. During 2022-23, rains accompanied by hailstorms acted as a spoiler. During the first half of FY 2023-24, food inflation went up due to a spike in the prices of vegetables caused by seasonal factors. The current inflationary trend in food prices also has to do with supply-side pressures only. The RBI can achieve little to control them by keeping the policy rate high.

The RBI should take the idea mooted in the ES – 2023-24 on board. Meanwhile, it should consider reducing the weight of food inflation in CPI to reflect the contemporary reality. The current 40 per cent weight is based on the Consumption Expenditure Survey (CES) of 2011-12 whereas Summary Statistics from the 2022-23 CES point towards a significant reduction.  While formulating its monetary policy, the RBI’s prime responsibility is to ensure macro-economic stability its pivotal focus being on keeping inflation within reasonable bounds. However, it can’t be oblivious of the dire need to support economic growth which could be adversely impacted if it keeps the interest rates high.

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