For much throughout the pandemic, India’s central bank has been making crucial decisions for the economy—trading off between inflation and growth. If the object of India’s Central Bank is to be scrutinized, monetary policy committee (MPC) throughout the pandemic has kept it straightforward: don’t rock the boat. It is no news that the second wave of the pandemic has increased the uncertainty around the near-term growth outlook.
But given latest economic numbers, India has been seen recuperating from the pandemic as various indexes indicate growth. Moreover, given India’s falling infection rate, it can be maintained that economy would not have to impose yet other stringent lockdown to curb the virulent nature of the pandemic and hence the economy will be given some space to breath.
RBI, throughout the pandemic, has kept an accommodative stance prioritizing growth over inflation. But after one successful year of maintaining such stance, RBI now finds itself in troubled waters as headline inflation looks likely with burgeoning WPI and CPI numbers. Moreover, public has already been feeling the pinch of increasing fuel prices and has been demanding its inclusion in the GST regime.
However, RBI is of the stance that India is facing transitory inflation which will much likely recede in future. Moreover, the output gap is still negative and the recovery has not yet been secured, thus growth measures and RBI’s accommodative stance appears the right strategy. Thus, RBI at the moment finds itself at the crossroads of difficult choices—to maintain its accommodative stance at record low rates or to end its accommodative stance at high rate.
The MPC may choose to give a fresh time-based guidance, or one or two additional quarters, to stay accommodative, or shift to a state-based guidance but an immediate overhaul to control inflation seems highly unlikely. On the other hand, markets seem to prefer the former choice of an accommodative stance, but given the circumstances, the MPC should opt for the latter to give itself maneuverability over the medium-term for various reasons.
Why inflation needs to be controlled?
First and foremost is the economic stimulus of Rs. 6.28 lakh that has been recently introduced by the government. Given rising inflation in economy, an economic stimulus just adds to the money supply of the economy and hence inflation. Though, it is to be noted that the economic stimulus is a replica with some repeated measures of the last stimulus, but its impact is too crucial to be ignored.
Secondly, the economic impact of the second wave will be limited, owing to less stringent lockdowns and as consumers and businesses have adapted to the new normal. To support this claim, high-frequency data has suggested that while mobility and passenger transport has been hit, the goods sector continued to chug along. In addition to this, growth should also be supported by medium-term tailwinds from ongoing vaccinations, a synchronized global growth recovery and lagged effects of easier financial conditions. Hence, while sequential growth may weaken during April-June but growth, at the moment, doesn’t seem like a far-fetched idea as it did previously.
Thirdly, risks to underlying inflation are burgeoning. It is to be noted that near-term inflation moderation is largely due to the volatile vegetable component. Whereas higher freight costs and a broad-based rise in commodity prices have squeezed manufacturers’ profit margins and resulted in some of these costs being passed to consumers. Though the recent WPI and CPI data show that producer’s cost has not yet been transferred to consumers but it is only a matter of time before it does. Initially, services inflation was subdued, but there is early evidence of higher prices in categories like recreation.
While policy continuity could be the correct strategy in the near term, the medium-term or long-term growth-inflation tradeoff argue for gradual policy normalization. This calls for an effective measure to assign higher weight to inflation, relative to growth. Thus, RBI which currently faces a conundrum to make a sagacious choice for the economy, it will be interesting to see which strategy it prioritizes, whether it will be its