MONETARY POLICY

1. Context 

2. Key Points 

• The RBI cut India's GDP (Gross Domestic Product) growth forecast for the current financial year, maintained the inflation forecast and raised the repo rate by 35 basis points.
• Even though the raising of the repo rate by 35 basis points is in line with market expectations, most observers saw the latest policy statement as "hawkish".

3. Need for monetary policy

• In India, the RBI is entrusted with the responsibility of devising monetary policy "with the primary objective of maintaining price stability while keeping in mind the objective of growth".
• The central bank is supposed to target a 4 per cent retail inflation level, although the RBI has the leeway of inflation going up to 6 per cent or falling to 2 per cent in any particular month. 

• Think of the reverse: if everyone thought things will be cheaper tomorrow or next month, they would defer their purchases and the economic activity would contract.
•  When inflation runs high,  RBI raises the repo rate the interest rate it charges banks when it lends them money. 
• Doing this incentivises savings and disincentives expenditure thus curtailing overall demand and GDP. That in turn, reduces the inflation rate.
• In times of weak economic activity, RBI cuts the repo rate and by the reverse logic, boosts demand and economic output.
• All these decisions are taken by the MPC, which meets once every two months to assess inflation and growth outlook.

4. Significance of the latest policy review

• Indian policymakers are facing an odd quandary.  
• Over the past couple of years, India has had to deal with a scenario where inflation has been high even as economic output struggles to grow.
• This has happened for a variety of reasons. 
• In particular, India was already experiencing a severe growth slowdown before the Covid pandemic.
• This was made worse by the lockdowns during Covid, while inflation shot up on account of supply disruptions, first due to the pandemic and then due to Russia's war in Ukraine.
• For a while, the RBI has prioritised economic recovery but that has meant high inflation, which hurts the poor the most, since the start of 2022, inflation has been above the 6 per cent mark.
• The RBI has to explain to the government why it let this happen.

5. Latest outlook on inflation and interest rates

• The MPC has maintained the forecast for headline inflation (the total inflation in an economy) in the current financial year at 6.7 per cent.
• In the October to December (Q3) quarter, RBI expects it to be 6.6 per cent and in the January to March 2023 (Q4) quarter at 5.9 per cent.
• The RBI has also projected that overall inflation will be 5 per cent in April to June 2023 quarter (Q1 of the financial year 2023-24) and 5.4 per cent in the July to September quarter (Q2 of the financial year 2023-24).
• In other words, as things stand, even RBI expects headline inflation to stay above the 6 per cent mark for 15 straight months.
• Even after that, hitting the 4 per cent level will likely take time.
• This implies that even though RBI may not raise the repo rate by much from here on most expect another 25 basis point increase in February it is likely to stay at that level for a year, before considering a cut.

6. RBI's stance (Hawkish)

6.1  Core Inflation 

•  Consumer Price inflation moderated to 6.8 per cent (y-o-y) in October as expected, but it remains above the upper tolerance band of the target.
• Core inflation is exhibiting stickiness on balance, the MPC was of the view that further calibrated monetary policy action is warranted to keep inflation expectations anchored, breakcore inflation persistence and contain second-round effects.
•  Core inflation is arrived at by removing the inflation in food and fuel from headline inflation. By removing food and fuel inflation (Since these prices fluctuate more wildly), core inflation provides a more robust measure of inflation in the economy.
• The trouble is: If core inflation is high, it takes a while to come down because it implies that inflation has become broad-based (i.e. higher prices have seeped through all parts of the economy).
• RBI traditionally targets the headline rate, which is moderating.
•  Core inflation, on the other hand, is going up and thus, it may push the RBI to take a more hawkish stance from here on.

7. GDP growth

•  The RBI has cut the GDP forecast marginally for the second MPC in a row.
• It now expects the GDP to grow by 6.8 per cent in the current financial year.
• As the data shows, in September it cut the GDP forecast for the full year but raised the quarterly GDP forecast.
• This time it has cut both full years as well as the quarterly forecast.
• However, even now, the quarterly forecasts for GDP growth in Q3 and Q4 are higher than what the RBI pencilled in April.
• This is significant because, since April, repo rates have now gone up by 225 basis points.
• Higher interest rates progressively drag down the economy.

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