In recent weeks, there has been an intense debate on the RBI’s monetary policy stance, and its currency market interventions.
On the direction of monetary policy, it has been felt that the central bank is more worried about inflation, and less about growth. And that this has led it to keeping interest rates far more restrictive than what is required. This view has been articulated not only by former members of the monetary policy committee, but more recently by the government, a section of the market, and some analysts.
As early as February, when the central bank had projected inflation at 4.5 per cent for 2024-25, then MPC member, Jayanth Varma, had voted for a rate cut. Varma had argued that considering the inflation projections such a high real rate was not required to drive inflation down to the target of 4 per cent. In the June policy meeting, Varma was joined by Ashima Goyal, who argued that even after a rate cut of 25 basis points, “monetary policy would remain disinflationary towards bringing inflation credibly to the target”.
Comments from the central bank suggest that it has been unsure about the trajectory of food prices, and is worried about food inflation spilling into core inflation. Recent data which showed that inflation rose from 3.65 per cent in August to 6.21 per cent in October — does seem to have confirmed the RBI’s fears.
However, it has been argued that these concerns do not hold for several reasons. One, the surge in inflation is largely due to vegetables, which rose 36 per cent in September and 42 per cent in October. Excluding vegetables, inflation stood at just 3.3 per cent in September and 3.6 per cent in October. Second, there is little evidence of price pressures in the broader economy. Labour markets are weak, and wage growth has been subdued. Core inflation remains muted. As per a report in this paper (IE, December 1, ‘Amid slowdown, RBI-govt gulf widens, growth to holding rates’), even government officials have questioned the RBI’s views on price pressures in the economy. Third, what matters for monetary policy is inflation a few quarters down the line. And those expectations haven’t changed significantly. In October, the central bank expected inflation at 4.3 per cent in the first quarter of the next financial year. While it has now revised its projection marginally higher, to 4.6 per cent in the first quarter, it has pegged it to align with the target of 4 per cent in the second quarter.
On a forward looking basis, these projections imply a real interest rate of 2.5 per cent. In comparison, Varma had earlier argued that “a real interest rate of 1-1.5 per cent would then be sufficient to glide inflation to the target of 4 per cent.” Policy should be less restrictive as inflation is moving towards the target. Excessively tight policy will lead to a higher growth sacrifice.
As per comments from the RBI, it was “resilient” growth that provided the space to the monetary policy committee to “focus unambiguously on inflation”. This justification was provided even as the underlying economic momentum was slowing down with several indicators, including core inflation, pointing in that direction. An editorial in this paper (IE, October 26, ‘Shrinking pockets’) had also pointed out that the commentary from sections of India Inc was also indicating a slowdown in household demand.
The RBI’s rather exuberant views on growth were in direct contrast to even those of the government. As per a report in this paper (IE, December 1, ‘Amid slowdown, RBI-govt gulf widens, growth to holding rates’), government officials had questioned the central bank’s growth projections as far back as June. The August and September monthly reviews of the finance ministry had also spoken about the pain-points in the economy.
The second quarter GDP estimates have confirmed these fears. However, even as the RBI has revised downwards its GDP forecast for the year, the central bank views the slowdown as transitory in nature. It expects the economy to bounce back strongly. But, some are not sure. It does appear that the central bank has been too worried about inflation, and complacent about growth.
Then there is also the matter of the currency. The election of Donald Trump has injected a degree of uncertainty in the global environment. Markets are grappling with the possibility of Trump raising tariffs, which will be inflationary, and cutting taxes, which will raise the deficit. This would mean that the US Federal Reserve might not be able to cut interest rates by the extent that was previously anticipated. Put differently, interest rates will be higher than what was previously expected. This will strengthen the dollar.
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October and November also witnessed huge outflows of foreign investors from Indian markets. Foreign investors took out $13.6 billion during the two months (its net investments were negative), some of which was due to rebalancing of global portfolios in favour of China. All this has put the currency under huge pressure as an article in this paper has pointed out (IE, November 19, ‘RBI’s blind spots’)
During this period, the scale of the central bank’s interventions in the currency markets to defend the rupee was truly staggering. Between September 27 and November 22, RBI’s forex reserves fell by $48 billion. While part of it could be due on account of revaluation of reserves, the decline does give some indication of the extent of the central bank’s interventions. In the first week of December, foreign investors have bought back, net investments were $2.8 billion, but the pressure on the currency continues. In the December MPC meeting, RBI Governor Shaktikanta Das mounted a strong defence of the central bank’s currency interventions. He argued that the interventions were to smoothen “excessive and disruptive volatility”, and not to target any specific exchange rate level. But an interest rate cut could lead to capital outflows and further weaken the currency.
The next meeting of the RBI’s monetary policy committee is scheduled to be held on February 5-7. As an editorial in this paper (IE, December 7, ‘Inflation at centre’) has pointed out, by then, there would probably be greater clarity on the growth-inflation dynamics in the country, the stance of fiscal policy, and Trump’s tariff policy. This could then possibly create the conditions for the central bank to ease policy rates.
Till next week,
Ishan Bakshi
