The Reserve Bank of India (RBI) Governor Shaktikanta Das attends a news conference after a monetary policy review in Mumbai, India. (Reuters)
Dear Readers,
The six-member Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) met last week for the first monetary policy review of the new financial year (2022-23).
On the face of it, nothing happened. Both the benchmark interest rates — repo (the interest rate at which the RBI lends money to commercial banks) and reverse repo (the rate that RBI pays commercial banks when they park their money with the central bank) — remained unchanged.
Not just that. Even the policy stance — which essentially reflects the RBI’s approach and priority between containing inflation and boosting growth — remained unchanged (“accommodative”) as well.
To be sure, by stating that its stance is “accommodative” the RBI wants us to know that it will do everything in its power to support economic growth as long as it continues to meet its obligations on the inflation front.
And yet, this was the most significant policy review possibly in the past 24 months.
That’s because of two reasons. One, the RBI made dramatic changes to its forecasts of inflation — this was predicted in an ExplainSpeaking piece published on March 21 — and, to a lesser extent, economic growth. Two, the commentary coming out of the RBI explaining what it was trying to do.
A quick recap on RBI’s recent history The RBI is charged with maintaining financial and monetary stability in the country. The most important part of its job in this regard is to maintain price stability. Too many fluctuations in prices impede the smooth functioning of an economy. Imagine for a moment a scenario where you are not sure what the prices of different goods and services will be in the coming days, weeks or months; it will be chaotic functioning in an economy where prices go up and down wildly. The RBI is also the regulator of the banking system, ensuring banks are well capitalised and adhere to prudential norms so that consumers are well-served. But this particular role is less relevant for today’s discussion. The third role of the RBI is to manage the government’s borrowing. There is a remarkable conflict of interest between RBI’s role of maintaining price stability (read containing inflation) and its role in managing the borrowings of the government because as the former it may find it more feasible to raise interest rates (to contain inflation) but as the latter, it may find it more opportune to keep interest rates low. By law, India’s central bank is supposed to target an inflation rate of 4% per annum. In other words, RBI should tweak the interest rates in such a manner that retail inflation (the rate at which retail price level rises in a year) is 4%. The RBI has been given a leeway; it can allow the retail inflation rate to waver from 4% by two percentage points on either side. In other words, in a particular month, inflation can be 2% or 3% and on other occasions, it could be 5% or even 6%. However, there is a difference between a policy regime where a central bank targets 4% +/- 2% points and one that “targets” a range between 2% to 6%. In the latter, for example, it could be the case that inflation consistently stays too high (at or around 6%) or too low (at or around 2%) without ever hitting the sweet spot of 4%. Over the past few years, the RBI and the government have often been at loggerheads over how to tweak the interest rate. The current Governor, Shaktikanta Das, was appointed after Urjit Patel left office in late 2018 rather abruptly and before the scheduled end of term. Das, who had been a career bureaucrat and worked in the Union Ministry of Finance, was expected to smooth over the cracks between the divergent approaches of the RBI (wanting to control inflation by keeping higher interest rates) and the government (wanting lower interest rates to support economic activity). However, since late 2019, the Das-led RBI has been faced with an unenviable spectre: High inflation and faltering economic growth. Over the past 24 months, the RBI has chosen to see through high inflation while trying to do whatever it could to boost growth. The end result was that the benchmark interest rates have been stagnant. They have neither gone up to contain inflation nor gone down to boost growth. As explained in several past ExplainSpeaking pieces, RBI's decision to see through inflation and routinely underestimating inflation contributed to perpetuating higher prices. What is inexplicable in the policy? As mentioned earlier, the most important change has been that the RBI has significantly revised its inflation forecast. As against a forecast (made in February) of a rather benign 4.5% for FY23, the RBI now expects it to be 5.7% for the current financial year. That is not all. Even for the financial year after that — 2023-24 — the RBI expects inflation to be 5.2%. And this shift has happened just in the last two months. In fact, during the press conference, Governor Das took the effort to declare that RBI will now prioritise (containing) inflation over (boosting) growth. At one level, this is a no-brainer because the RBI is legally mandated to contain inflation and target the 4% mark. Still, the fact that he said it implied that the RBI is finally declaring that it will no longer see through inflation. All this begs the question: If the RBI has so radically altered its inflation forecast and its approach towards higher prices then why hasn’t it raised interest rates or at the very least changed its policy stance from “accommodative” to “neutral”? A small part of the answer can be found in the fact that RBI has also dialled down the GDP growth forecast for the current financial year from 7.8% to 7.2%. Apprehensions about economic recovery not taking root have likely been a central reason why RBI has turned a blind eye to high inflation over the past two years. But still, it is now amply clear, even by RBI’s forecasts, that high inflation is here to stay. For example, RBI expects Q1 (April, May, June) inflation to be 6.3% and Q2 (July, August, September) to be 5.8%. Having allowed the inflation to overshoot the 6% barrier in Q4 (January, February, March) of last financial year, these forecasts imply that there is a very good chance that RBI misses out on keeping inflation under 6% for three consecutive quarters. That, in turn, will place it before the Parliament and force it to explain why it could not control inflation. Dove, Hawk or Pigeon? Typically, central banks and central bankers (that is, the Governors and the members of the Monetary Policy Committee) are either viewed as “doves” or “hawks”. Those central banks (or bankers) who have a very low threshold for tolerating variation from the targeted inflation level (or a range), and who keep their eyes peeled for such divergence, and immediately swoop in to raise interest rates are called “Hawks”. “Doves”, on the other hand, favour boosting growth (by keeping the interest rates low) and are far more willing to risk having higher inflation. However, the equivocation in what the latest policy says on paper and its explanation makes it difficult to understand what is the real intention of the RBI. Does it want to say that the RBI has seen enough of high inflation and would actively work towards containing it? If so, then why not change the policy stance at least? If, on the other hand, it still believes that since inflation is within the broad range of 6%, and since growth is still quite iffy, it would like to continue supporting growth then why say that inflation is now its first priority? There is another term, which is far less common than a dove or a hawk but it could be used to describe the RBI. A “Pigeon” refers to a central bank that falls in between the doves and hawks. Essentially, a pigeon is characterised by monetary policy inertia. It has been argued that those MPCs where there is no single head and which try to arrive at a decision by consensus tend to become pigeons. According to Donato Masciandaro (Full Professor of Economics, and Chair in Economics of Financial Regulation, Bocconi University), often the “doves” and “hawks” in the MPC tend to moderate each other’s extreme positions. The desire not to lose out — loss aversion — tends to push more and more members towards becoming pigeons. This, in turn, explains the delays and lags in monetary policy. To be sure, India’s MPC is not run by consensus and has often arrived at a decision by a simple majority. Yet, the pigeon terminology provides another way to understand what might be happening to the RBI.
What are the policy implications for the government bond market? The government bond yields have been going up because market participants — read investors — can also see higher inflation coming their way. Higher inflation implies that the current bond yields will be insufficient to recompense bond investors. As such, the demand for bonds is falling. This is leading to a fall in bond prices, which, in turn, is leading to a rise in bond yields.
That’s it for today. Hope you have watched the latest episode of The Express Economist. This week it features Louis Kuijs (Chief Economist, Asia Pacific at S&P Global Ratings) to understand why India must grow its manufacturing sector if it wants to raise per capita incomes. Stay safe Udit If you received this newsletter as a forward, you can subscribe to it, here. Do read our other Explained articles, here | To subscribe to our other newsletters, click here | 
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