Can RBI Quell India’s Inflation?

 (A version of this article appeared in Moneycontrol.com on 09June2022 per link below

https://www.moneycontrol.com/news/opinion/can-rbi-quell-indias-inflation-8661921.html )

Can RBI Quell India’s Inflation?

 

The Monetary Policy Committee (MPC) today raised their estimate of India’s fiscal year 2022-23 (FY23) Consumer Price Index (CPI) inflation to 6.7%, a full 1.0% higher than their previous estimate two months ago. Given the trends in energy and commodity prices in the wake of the Russia-Ukraine conflict, continued strains in global supply chains, and the incomplete pass through of much of these increased costs, our actual FY23 inflation could well cross 7.0%. 

 

Since 2016, when India formally enshrined inflation targeting into the RBI Act, the MPC is mandated with keeping inflation within a range of a target CPI inflation (currently set at 4%, +/- 2%) by changing the policy repo rate appropriately. Even as most economists welcomed this development, from an MPC perspective, controlling India’s inflation can be quite a challenge.

 

Nearly 53% of India’s CPI consumption basket comprises items of food and energy. In addition, energy prices directly feed into other components of the basket, such as transportation. Economists acknowledge that changing policy repo rate will do precious little to directly control the prices of these components. Further, as the RBI Governor explained today, around 75% of the increase in India’s inflation estimates can be attributed to the rise in food and energy prices, because of the ongoing war. 

 

The architects of the current MPC mandate were well aware of this drawback. They reasoned, however, that even if inflation was largely on the back of food, energy and commodity prices, monetary policy had a role to play in controlling overall demand and economic activity, and hence preventing generalized inflation and inflation expectations from taking hold. In fact, as things stand, inflation is indeed becoming generalized. Core inflation (ex-food and energy) grew at 7.0% year-on-year in April 2022, and it could well stay close to that level for the rest of FY23.

 

Therefore, should the MPC now raise policy rates rapidly and bring down aggregate demand? While it is tempting to rush to that conclusion, it is worth thinking this through. Do we really have excessive demand? More importantly, do we really have excessive demand fostered on the back of low repo rates and excess banking liquidity? 

 

On the question of demand, as per our Central Statistics Office (CSO), India’s real Gross Domestic Product (GDP) for FY22 was at INR 147 lakh crores, hardly changed from the FY20 level of INR 145 lakh crores two years ago. Within this, private consumption for FY22 was at INR 84 lakh crores, practically unchanged from two years ago. With near-zero growth in real consumption over two years, it is difficult to make the case that our demand is excessive. If anything, we likely need much more of both consumption and investment to foster job creation and domestic output.

 

Nevertheless, let us go with the purist canon that ultimately, demand sacrifice is required at the altar of inflation control. How then will raising repo rates and drawing down banking liquidity help arrest aggregate demand? 

One route through which this should work is via the impact on banking credit growth. As short-term policy rates rise, and as banking liquidity is drained out, money market rates increase, and the cost of banking loans go up as well. An April RBI report found that 40% of all banking loans are now linked to short-term external benchmarks such as the policy repo rate and Certificate of Deposit (CD) rates. RBI’s monetary and liquidity actions have pushed up 1-year money market rates from below 4% in August 2021 to over 6.25% now. As the cost of loans go up, less new loans are disbursed, therefore crimping aggregate demand. 

 

It is worth noting, however, that our current 12.1% year-on-year banking credit growth is well below the FY22 nominal GDP growth of 19.5%. It is again very difficult to make the argument that credit growth is resulting in ‘excessive’ demand. If anything, credit growth will probably need to grow faster, to support higher working capital requirements (given inflation), and much-needed higher investments. 

 

Does this mean that monetary policy can do very little to quell inflation in the current context? Not exactly. This is where the concept of ‘real rates’ comes into the picture. As per the RBI, the weighted average term deposit rate across all banks was an all-time low of 5.03% (pre-tax) as of April. This at a time when inflation expectations amongst households are in double-digits. The ‘real rate’ – returns on fixed income adjusted for inflation and tax – have been at record (negative) lows.

 

Over the past two years, with RBI keeping long-term bond yields low as a ‘public good’ to benefit the governments and their borrowing programs, savers have been short-changed. Fixed income savings – particularly on a post-tax basis – have resulted in a significant erosion of wealth. Younger and richer savers have been pushed out of fixed income savings, into riskier asset classes such as equities and bitcoins, or into conspicuous consumption (witness the increase in demand for select luxury goods). Higher real rates can help arrest some of this asset inflation and resultant inequity, and perhaps channel savings into long term debt markets.

 

To be fair to the RBI, the ongoing increase in long-term bond yields (10-year GOI closed today at 7.5%) can help address this issue of real returns for savers. It may well be worth exploring some significant tax relief for fixed income savings, to further improve the real rates for savers. 

 

In summary, much of the current inflation is directly caused by factors outside of monetary control. It is very difficult to make the case that demand – or credit growth - is currently excessive. To that extent, a rapid increase in short-term rates and a rapid withdrawal of banking liquidity might do little to alleviate inflation, while impacting investment and job creation. Instead, higher long-term real rates for savers might well be our best bet to preserve all-round financial stability.