RBI Monetary Policy: Necessary for Appearance but Unlikely To Make Difference

RBI Governor Shaktikanta Das 

(Photo: Altered by The Quint)

The Reserve Bank of India's (RBI) statutory mandate is to secure monetary stability in India. The Government of India, using powers under the Amendment to RBI Act in 2015, has prescribed maintenance of consumer price index (CPI) inflation within the corridor of 4 percent plus or minus 2 percent. The RBI also influences inflation by adjusting liquidity in the system.

If the CPI or consumer inflation increases beyond 6 percent, RBI fails statutorily.

Consumer inflation was 7.01 percent in June 2022 and has been much higher than 6 percent since January 2022. Excess liquidity has been Rs 3.8 lakh crore in June-July 2022. Quite clearly, the RBI has not been able to deliver on its inflation mandate.

The RBI decided to hike its short-term funds lending rate (repo rate) by 50 basis points on 5 August. It continues to remain accommodative, though its official stance has been ‘withdrawal of accommodation’ since the last policy meeting.

Will this policy stance work? Can it bring inflation below 6 percent?

More a Proforma Measure Than an Impactful Action

The Consumer Price Index (CPI) inflation underplays the real inflation in India. The wholesale price index (WPI) inflation was 15.18 percent in June 2022 and has been running in excess of 13.5 percent for the last six months. India's economy-wide inflation (measured by the GDP deflator, which is the difference between the nominal and real GDP growth rates) was in excess of 10 percent last year.

From this wider, and real, inflation perspective, the RBI is much more off-track on the inflation front.

If one goes into the real reasons for inflation, it becomes clearer that the current high inflation in India is largely the result of supply-side dynamics in the real economy.

India imports heavily. Prices of major import items like crude oil, edible oil, capital goods, electronics etc., have all gone up sharply. The foreign exchange rate has depreciated by more than 6 percent in the last six months. This imported inflation has been a major contributor to inflation. The RBI perhaps cannot do much about it.

Domestic product prices have also been rising. Food inflation was uncomfortably higher at 7.56 percent in June. Clothes and footwear inflation exceeded 9.5 percent. Cereal inflation is inching upward with wheat and rice prices rising. The RBI does not have much role to play in such domestic inflation as well.

The RBI's role in inflation management is on the demand side, which it can manage by adjusting money and credit supply.

The RBI followed an expansionary monetary policy post COVID-19, after March 2020. It also kept interest rates low, hoping for credit expansion. However, these measures did not work until the first half of 2021-22. Most of the liquidity unleashed was surrendered by banks to the RBI.

Credit growth dynamics, however, changed from the second half of 2021-22. Credit demand picked up as the cost of building materials and other commodities rose. Credit growth exceeded 8 percent in January 2022 and steadily went up thereafter – 11 percent in April, 12 percent in May, 13 percent in June, and 14 percent in July.

The RBI started raising repo rates from May 2022 – from 4 percent to 4.4 percent. With two more rate actions thereafter, the repo rate has increased to 5.4 percent now. Ironically, credit expansion has accelerated in these months, from 11 percent to 14 percent.

Clearly, the rate increases have not been effective in controlling credit expansion.

Inflation is the result of many factors – changes in the real economy, governmental policy actions, and global inflation. Inflation is likely to come down in coming months when these elements change.

The RBI policy will not, however, contribute to that. The RBI policy rate increase will likely remain more of a proforma action.

Rate Action May Have Favourable Impact on Exchange Rate

The dollar is the international currency for India. The rupee's exchange rate to the dollar is its external value. While the RBI's policy actions are not intended to influence exchange rate, these do impact indirectly.

India continues to be in large deficit in current account, which is quite likely to see a deficit in excess of $100 billion in 2022-23.

There is a serious likelihood of advanced economies sliding into recession or major slowdown. As a result, we might get relief on commodity prices but we are likely to lose on exports. Our imports are more inflexible. Overall current account deficit may not change much.

India has been receiving substantial capital account flows which have usually off-set the current account deficits maintaining external value of rupee and keeping rupee depreciation in check. The RBI, by buying or selling the dollars from the market whenever demand and supply gets temporarily mismatched, has ensured orderly conditions in foreign exchange markets.

This comfort zone, however, got disturbed in the last 10 months. Substantial outflows of portfolio investments took place. There was deceleration in inflows in government debt, external commercial borrowings and NRI deposits also. The RBI sold over $60 billion in last six months to bridge the gap. Such depletion can impact rupee-dollar exchange rate badly if it continues any longer.

Debt capital flows depend largely on positive difference in net hedged earnings foreigners make on their investments in India vis-à-vis what they get in the US.

Recessionary fears in the developed markets has reduced returns on US deposits/bonds in last few weeks. Despite US Fed increasing the federal funds rate by 75 basis points in July, yield on 10-year paper is about 40 basis points lower than two months back. This reduction has improved relative attractiveness of Indian bonds.

By increasing repo rate by 50 basis points, the RBI has provided an upward push to Indian yields. This should further improve the net returns for the non-residents which will give a positive push to capital account inflows.

In sum, unless there is another shock or the US policy becomes still more hawkish, any deeper depreciation of rupee exchange rate does not seem warranted for the present.

The RBI policy action may not have any real impact on Indian inflation but might as well do a favour by providing stability to the exchange rate.

(Subhash Chandra Garg is Chief Policy Advisor, SUBHANJALI, author of The $10 Trillion Dream, and former Finance and Economic Affairs Secretary, Government of India. This is an opinion article and the views expressed are the author's own. The Quint neither endorses nor is responsible for them.)