Use monetary policy with care

Yet, the RBI woke up from its slumber only in May, being compelled to pull out its Brahmastra – the monetary policy – to hike the policy repo rate by 40 bps

The Indian economy is going through a tumultuous period. While slow recovery from the pandemic is a concern, high prices and depreciating Rupee have also become bothersome. According to RBI’s own publication, inflation in wholesale price index (WPI) was in the vicinity of 13 per cent since last November and Consumer Price Index (CPI) inflation had breached the upper tolerance level of the ‘safe band’ in January. Further, the Rupee had slid by about 3 per cent in the last quarter of the last fiscal.

Yet, the RBI woke up from its slumber only in May, being compelled to pull out its Brahmastra – the monetary policy – to hike the policy repo rate by 40 basis points (bps) in May and by 50 bps in June; even ‘robbing’ the commercial banks by increasing the Cash Reserve Ratio (CRR) by 50 bps. The policy, however, seems to have had little effect on inflation or on the falling Rupee. Was the Monetary Policy Committee (MPC)’s decision to stimulate policy rates delayed because it was incapable of assessing the economic scenario or were there other motives for it?

I had suggested (DH, Jan 5, 2022) that the RBI’s monetary instruments would be incapacitated by the Finance Ministry as the latter would have plans for an expansionary fiscal policy, which may fuel inflation. An acknowledgment of inflationary pressures would have thwarted the ministry’s plans to increase expenditure. Further, raising policy rates would have forced the government to borrow at higher interest rates.

Read | Monetary Policy: Just flawed logic or toeing FM’s line?

Given these considerations, it seems that the MPC could revise its stance only in April, and could finally raise the policy rates in May. Thus, it appears that RBI procrastinated at the behest of the Finance Ministry. The question remains: Can tweaking policy rates help mitigate inflation and Rupee depreciation?

Monetary policy aims at controlling money supply in the economy by adjusting key policy rates. The MPC votes on the repo rate and sets the Marginal Standing Facility (MSF) rate and Reverse Repo rate as the upper and lower bounds respectively – termed as the channel system. MSF is a window for banks for overnight borrowing from RBI at a penal rate while reverse repo rate (until March 2022) would set the minimum rate for banks to park their resources with the RBI.

In April, the reverse repo rate was replaced with the Standing Deposit Facility (SDF) rate as the lower bound. The rate was set at a higher level, narrowing the policy corridor. These steps, however, resulted in little success. To devise an efficient and effective economic policy, a thorough understanding of the source of inflation and currency depreciation is required.

Inflation in India in the current context is majorly supply side-driven. Global supply chain disruptions leading to severe shortages have adversely affected production processes. While the impediments caused by the pandemic were being fixed, the Russia-Ukraine conflict created another set of uncertainties, leading to spikes in oil and input prices. These spikes in global prices have transmitted to domestic prices, causing inflation in India. Restrictions on food imports due to the war may also have contributed to food inflation, a major contributor to overall inflation.

Monetary policy primarily aims at affecting the aggregate demand in the economy. A tight money policy – hiking policy rates – will increase the cost of borrowing and spending, thus constraining consumption and investment in the economy. This may restrict demand and production activities, causing recessionary pressures. This would spell disaster for an economy that is still suffering from the trauma caused by the pandemic.

Another concern is the steady depreciation of the Rupee over the last quarter. Inflation in the US does not seem to be mitigating, requiring the US Federal Reserve to hike policy rates. This has led to an outflow of capital from India, causing the Rupee to depreciate. The rate of depreciation has been partially pacified by depleting forex reserves and by promoting international trade through the Rupee. Yet, neither one of these is strictly a monetary policy.

The Indian policymaker is in a dilemma – whether to control inflation or to stimulate growth, and how to arrest the fall of the Rupee. The RBI has resorted to its Brahmastra of hiking policy rates. Yet, the policy seems to have brought little relief in managing inflation. The MPC should take cognisance of the source of inflation and currency depreciation while proposing the next round of interventions. The Brahmastra can be both constructive and destructive, and judicious use is warranted.

(The writer is Professor, Department of Economics, Alliance University, Bengaluru)