For three years, the Reserve Bank of India (RBI) had put economic growth ahead of taming inflation as its priority, despite the consumer price index breaching 6% several times in the past six months. The central bank had reduced interest rates and kept the policy stance accommodative, flooding the market with excessive liquidity.
On Friday, April 8, RBI Governor Shaktikanta Das said that this would change—inflation would be prioritised over growth and the accommodative stance could be changing. This was despite the fact that RBI had to lower its GDP growth estimate for 2022–23 from 7.8% to 7.2%. And despite the fact that just a couple of weeks earlier, while addressing a CII meet, he had reiterated that the RBI planned to remain focused on growth.
Though the policy rate and stance remained unchanged on Friday what made the RBI governor signal that priorities were changing? And will the RBI succeed in taming inflation any better than its efforts to spur GDP growth?
The answer to the first question is easier than that of the second. The global crisis and the soaring prices of commodities had made inflation difficult to ignore for the central bank. The RBI is now projecting that inflation will be 5.7% for 2022–23; a forecast many think is overly optimistic given the latest inflation numbers that came out yesterday. Earlier, the central bank had projected the full year’s GDP growth at 7.8% and inflation at 4.5%. The RBI’s medium-term inflation target is set at 4% with a tolerance of plus/ minus 2% on both sides.
The RBI may have also finally realised that the monetary policy’s ability to spur GDP growth is limited and the side effects of ultra-low rates are not always benign. Real interest rates have been in the negative territory—hurting savers and helping borrowers—for a very long time now. The ultra-low interest rates and excess liquidity were perhaps needed to counteract the shock of the pandemic and the lockdown, but it had reached the point of diminishing utility. Quarterly GDP growth—after a sharp rebound from a low base—was now beginning to show a more moderate growth trend.
The RBI may have also been conscious of the fact that studies in other countries had pointed out that the effects of low interest rates tend to help richer citizens and bigger companies than they do smaller firms or the poor. Low interest rates tend to disrupt the saver, hurt the poor and the retired disproportionately. And the pandemic had increased the number of poor in the country—many of whom are dependent on the savings they accumulated in better years. Other research has also pointed out that low interest rates could lead to market consolidation and dominance as bigger firms take advantage of them and crowd out smaller firms that cannot get cheap loans.
Indeed, the RBI is probably aware that there are plenty of signs that the same story is playing out in the way the Indian economy is recovering. Even while big corporations are showing higher profits, a large number of small and medium enterprises are struggling to keep their heads over water. And the unemployment situation remains worse than it was in the pre-pandemic days. And in the couple of years preceding the pandemic, the unemployment situation was not particularly good either.
And despite the ultra-low interest rates, private consumption remains sluggish and investment in greenfield projects has been anaemic. The latter can perhaps be explained by the fact that RBI’s own surveys show that capacity utilisation has remained stubbornly below 80% for years now, thus making it unnecessary to go for capacity creation in most sectors.
Whatever the reason, RBI finally seems to have made up its mind that now consumer price inflation has reached a point it can no longer ignore. How quickly will the RBI act on the inflation front given that the interest rates were not changed this time either though it took a step to reduce liquidity by introducing the standing deposit facility at 3.75%? Several RBI watchers expect graduated steps—with the liquidity normalisation being a multi-year process and the interest rates going up by 50 basis points by the end of the year.
Will this be enough to tame the soaring inflation? Economists have pointed out that the current inflation is largely because of supply-side issues, not demand-led. And therefore the weapons in the RBI’s armoury—higher interest rates and tighter liquidity—may not be particularly effective against it. The monetary policy measures work better in demand-led inflation but all statistics point to the fact that demand is yet to recover fully to the pre-pandemic levels.
For targeting the supply-side problems, the government’s fiscal policies—cutting taxes on fuel for example or reducing tax rates on some imports—may be far more effective in tackling the current inflation than anything the RBI can do. The governor may well be hoping that the Union government is as accommodative to the RBI’s current priority of taming inflation as the central bank has been in the government’s quest for faster growth.
Senior business journalist