Inflation may well become RBI’s friend with benefits

There is a saying that the wise choose their friends carefully and, perhaps, their enemies even more. But sometimes the lines get blurry. Seen through the prism of an old aphorism – about keeping friends close but enemies closer – a slightly hazy picture of the country’s current economic management philosophy seems to emerge.

It’s still early days, but the Reserve Bank of India (RBI) seems to be picking its shoal of friends for next year and, surprisingly, inflation might find a place on the list. Looking at all the tea leaves and coffee scraps, it might be fair to wonder if India’s central bank has gotten comfortable with a slightly higher level of inflation, albeit within its legally mandated tolerance zone. .

At its last bi-monthly monetary policy meeting for 2021-22, RBI decided to maintain the status quo by leaving rates alone and maintaining its dovish stance. The policy stance remained unchanged, despite consumer inflation hitting nearly 5.6% in December, a hair’s breadth from its upper tolerance limit of 6%. Bond markets and analysts, who were expecting some action on liquidity, were pleasantly surprised.

The central bank may have decided to stick to its existing playbook, as it believes inflation rates could moderate by the first half of 2022-23, driven mainly by inflation expectations. a good harvest of rabi and decongested supply lines further depressing food prices. The central bank’s inflation forecast for 2022-23 at 4.5%, however, seems extremely optimistic and at odds with all other indicators (rating agency Crisil’s assessment is 5.2%).

But then, RBI is not entirely ruling out the risks – from rising commodity prices, especially crude oil, or a domestic supply chain pregnant with the pass-through of high commodity prices. In the final analysis, the central bank’s gloomy internal growth estimates for the second half of 2022-2023 (October 2022 to March 2023) may also have lost their hand: 4.3% for October-December 2022 and 4.5 % for January-March 2023.

In the trade-off between fighting a higher inflationary regime and fixing weaker economic growth, the Monetary Policy Committee (MPC) appears to have concluded that faltering growth requires more attention. The central bank’s discouraging growth estimates also send an interesting signal: the MPC seems to express some skepticism that the budget’s large allocation for investment spending will allow the announced growth targets to be met.

Some quarters believe that a slightly higher inflation rate may not be so bad for the Indian economy, especially for private consumption demand. Consumers tend to postpone purchases in a falling price regime, hoping to get a bargain at a lower price later. When prices remain high for long periods, inflationary expectations encourage consumers not to postpone purchases. Economist John Maynard Keynes called this the paradox of thrift: long-term low inflation encourages consumers to save more rather than consume, which dampens aggregate demand, leading to lower aggregate output and an economy weaker.

The US Federal Reserve, which has announced its intention to raise interest rates to stifle rising prices, is urged not to use the mass and risk the US economic recovery. Nobel laureate Paul Krugman, who has spoken of braking rather than slamming on it, recently wrote in the New York Times: “A temporary period of high inflation, followed by a return to normal, is in fact the appropriate economic response to the particular constraints of recovery from the pandemic recession. »

It should also be remembered that monetary policy generally works with leads and lags; any MPC action will take time to cycle through the system and achieve the desired effect. Timing is therefore crucial. There are also a lot of things in the mix that are still unclear. How does wage growth fit with the rate of inflation? Or will corporate profits rise faster than prices to allow for meaningful debt management? What does rising prices mean for macroeconomic management, especially conservative nominal budget estimates?

It might be necessary to clarify here that RBI does not endorse runaway inflation rates. The amended Reserve Bank of India Act directs the central bank and the MPC to keep the retail inflation rate at 4%, but within a range of 2-6%. Failure to adhere to this designated band for three consecutive quarters would require RBI to account to the Center. The RBI bulletin should detail the reasons for the failure to meet its inflation target, the corrective measures proposed to bring inflation back to the 2-6% range and the time frame in which this can be achieved.

The interesting part is that the law says nothing about consumer inflation above 4% but below 6% for long periods. It is therefore very likely that the RBI will not pull back if consumer inflation continues to hold between 5% and 6% in the near future.

The RBI scorecard is currently cluttered with competing variables: a high rate of inflation; a persistent output gap; late consumption request; slow growing; slow credit withdrawal; a growing current account deficit; pressure on balance of payments and exchange rates. In anticipation of the coming storm, RBI will have to choose, much like the “impossible trinity”, the parameter or parameters it wishes to control or influence. By current calculations, it appears that tepid growth ranks highest on RBI’s radar.

Rajrishi Singhal is a political consultant, journalist and author. His Twitter handle is @rajrisishinghal.

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