Too much reliance on monetary policy instruments such as a hike in repo rate is of little help

Having already increased the repo rate or RR (interest rate at which the Reserve Bank of India lends to banks) by a cumulative 2.5 per cent in the past 11 months, the RBI’s six-member Monetary Policy Committee (MPC) on April 6 voted unanimously to keep it unchanged at 6.5 per cent. However, RBI Governor Shaktikanta Das pledged to hike the RR again if needed, saying the decision to pause was “for this meeting only”.

In 2016, the Government put in place an institutionalised framework, the MPC, to formulate monetary policy and determine the key interest rates. It mandated the RBI to fix rates, especially the RR, 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 the case of a failure to maintain the inflation target for three consecutive quarters, the central bank is required to submit a report to the Government explaining the reasons and spelling out the remedial actions it would be taken to check the price rise. For the first time, this situation arose during 2022 when the CPI remained above the higher end of the range i.e., 6 per cent for three consecutive quarters beginning January 2022.

Post-September 2022, the MPC brainstormed on the subject matter but its report is not in the public domain. Meanwhile, it has continued to deliver more hikes in October, December 2022 and February 2023 adding to 1.1 per cent on top of 1.4 per cent already delivered in June and August 2022 policy reviews (besides May 2022 which was out of turn). In the policy review announced now, it has paused but its tight orientation remains intact.

This is evident from a concomitant decision of the MPC to retain 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 RR and an increase in credit availability. Withdrawal of accommodation is its reverse implying that the RBI would go for more hikes in RR and less cash with the banks. It shifted to this stance in June 2022 and has stuck to it to date.

Have the measures taken by RBI helped in reining inflation?

The cue is available in the following statement by Shaktikanta Das: “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 percent (February 2023)”.

Das took charge in December 2018 when growth was emerging as a major constraint (from the third quarter of 2018-19 onwards, GDP growth was dipping) even as the RR had reached a peak of 6.5 per cent. Beginning in February 2019, he went for an aggressive cut in RR which had plummeted to 4 per cent by May 2020.

Despite the cuts, growth didn’t revive. During 2019-20, it had 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, when the pandemic effect waned, GDP growth rebounded to 8.9 per cent. Low-interest rates helped revival.

Meanwhile, a spurt in inflation from January 2022 onwards forced the RBI to shift focus to inflation management which has continued all through 2022-23. During 2022-23, even as GDP grew by 7 per cent, inflation remained stubborn. This is despite the RBI having raised RR to 6.5 per cent. The Governor admits it when he says, “Now, the policy rate is 6.5 percent but inflation is 6.4 percent”.

The hike in interest rates hasn’t helped. To say that inflation would have been much higher but for a hike in the RR is a tautological argument. The central bank has lowered its inflation forecast to 5.2 per cent for FY 2023-24 from 5.3 per cent (given in February 2023). This being lower than the threshold of 6 per cent at the upper end, it might not go for a further hike in interest rate. In case, however, inflation remains above this cap, it won’t hesitate to strike again. The RBI seems to be missing the wood for the trees.

Inflation is driven by both the demand and supply side factors. But the RBI is obsessed only with demand management, even though the spurt in inflation during 2022-23 was predominantly supply-driven. It was due to geopolitical tension and disruption in global supply chains (caused primarily by the Ukraine War), and the resultant steep increase in prices of commodities, mostly food, fuel and fertilisers.

India imports 85 per cent of its crude requirement and close to 55 per cent of natural gas (NG), both being the basic ingredients for making a whole range of products viz. petrol, diesel, LPG, CNG, PNG, ATF, etc. A major disruption in supplies from the war region has led to their skyrocketing international prices impacting the cost of their imports. In recent months, these prices have softened; for instance, last month crude declined to around $70 per barrel.

But this relief could be temporary. A slight change in global supply-demand dynamics could reverse the trend. For instance, the recent ‘sudden’ decision of the Organization of the Petroleum Exporting Countries (OPEC) plus to cut output by 1.16 million barrels per day (mbd) has led to a jump in the price of crude oil to $80 per barrel. According to Goldman Sachs, this could lead to oil hitting $95 per barrel by December 2023.

Another major source of inflation is food. The spurt in its price too 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 triggered by unusually high temperatures). During the current Rabi 2022-23 also, rains accompanied by the hailstorm in some areas have impacted wheat production. During February 2023, cereals and product inflation skyrocketed to 16.7 per cent. Likewise, inflation for ‘milk and milk products’ was high at 9.6 per cent.

This too was caused mainly by disruption in supply. In such a scenario, too much reliance on monetary policy instruments such as a hike in RR or sucking out liquidity (these instruments work on the demand side) is of little help. The RBI ought to have avoided it. But it hasn’t.

Continuing with this course 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. The RBI should abandon it; a mere pause in raising RR won’t take us very far. The RBI should change gear to make way for some cuts and provide adequate liquidity to support the growth momentum.

There should be a greater focus on supply-side management. Here, the government should play a bigger role by vigorously pursuing a strategy that reduces India’s vulnerability to disruption in the global supply chain. It should go for measures such as increasing domestic production of oil, gas, and fertilizers, diversifying their sources of supply, reduction in import duties, cutting in CED on petrol and diesel to bring them under GST within a specified time frame etc.

(The author is a policy analyst)