RBI shows resilience in the face of shocks
With the central bank saying it’s focused on fighting inflation, the predictability of its policy actions is restored
Aremarkable feature of India’s governance model in the last few years has been its ability to provide relative resilience in the face of unanticipated shocks. This is perhaps best reflected in economic management, which though, understandably not perfect, did navigate the economy and its economic agents through some very difficult times over the last two years, with relatively little damage, at least to the financial system in particular. As such, the decision of the Reserve Bank of India (RBI) to not proceed towards a more balanced policy stance earlier in 2022, and then suddenly raise rates in May did lead to the thought that the predictability of the policy regime that has served the Indian economy very well through the unprecedented times of the pandemic, may not be holding.
The messaging, though, from RBI is now clearer to the market. RBI is focused on containing inflation, which has risen to levels higher than that the system feels comfortable with. As RBI governor Shaktikanta Das said recently, rate hikes have become a “no-brainer”. But, as RBI has also made clear, while it is fighting to check inflation, most of the shocks to prices have emanated from factors beyond India’s control. Hence, while we need to acknowledge these negative shocks and make corrections, the central bank has maintained what could be described as a calibrated and measured tightening approach, rather than a reactive one.
To be sure, such a move was expected, and with RBI restoring the predictability of its policy actions, the season of speculation around potential policy moves is coming to an end. This is not to say that all risks are priced in. However, RBI can no longer be said to be “behind the curve”, especially since it has acknowledged through its inflation projections that it expects prices to rise further, and while doing so, growth too will be prioritised, so that the baby is not thrown out with the bath water.
Simply put, while bringing inflation down is an important priority, RBI is telling us that it will also respond to marginal data on growth to drive its decision making, and will not dogmatically pursue lower inflation, no matter what. As Das put it: RBI is not bound by stereotypes or conventions, and will do what it assesses to be the best course of action, based on economic data and hard facts.
This emphatic declaration perhaps also reflects that RBI no longer feels it is playing catchup with its peers anymore. And with RBI’s peers also fighting inflation worldwide, the tightening in global financial conditions will provide reinforcement to RBI’s own actions. While the central bank may perhaps be able to do little to curb imported inflation, the aspect over which it has most control -- domestic demand — has remained broadly manageable.
Indeed, while there are signs of some parts of the economy showing higher inflation, early actions such as reducing fuel taxes and increasing rates can prevent an entrenchment of inflation expectations. As per RBI, inflation expectations were reduced somewhat by the recent fuel tax cuts, and while it is improbable, Das did make a pitch for further use of counter-cyclical fiscal policies such as fuel tax cuts, especially by state governments, to manage inflation expectations and help household spending.
Looking ahead, economic managers can take significant lessons from the way India managed Covid-19. India followed a data-driven approach and responded to emerging challenges as they played out. Similarly, it is reassuring to note that RBI is cognisant of the tectonic shifts playing out in Europe, China and the rest of the world, and ready to minimise their impact on the Indian economy.
Domestically, India also appears to have effectively navigated the risks from the pandemic, and the variability of the southwest monsoon appears to be the biggest endogenous risk that the economy now faces, at least from an inflationary perspective.
It is also worth pointing out that while there have been fiscal support measures, RBI and the government have generally done well in avoiding policy mistakes. Still, with dark clouds gathering over the economy in the form of high energy prices, it will be timely to get our umbrellas out, and prepare the country for a downpour. The government and RBI will need to allow the economy to adjust to the new external realities and policy actions, such as cutting taxes and raising rates, will reduce the pain of adjustment at the margin.
Controlling inflation, too, will require joint action. The necessity for coordination has never been more strong than during the current situation, where the primary cause of higher prices remains external developments. Indeed, the objective of any coordinated action will not only be to hasten disinflation, but also reduce the need for aggressive monetary tightening. While interest rates will climb higher, some amount of economic growth is critical to ensure fiscal sustainability. Faster growth is necessary for keeping debt ratios in check.
The Covid-19 pandemic and the necessary fiscal expansion made by governments across the globe have pushed debt levels significantly higher, making financial conditions all the more critical.
It is in this context that RBI will have to continue to deftly manage its responsibilities of being the debt manager of the government, even as it strives to bolster its inflation fighting credibility.