Monetary Policy Meet Minutes: The Growth-Inflation Divide

The Monetary Policy Committee minutes showed that while some members are concerned over inflation expectations getting unanchored, others are concerned over growth amid a weakening global outlook.

The Reserve Bank of India's six-member panel hiked the benchmark repo rate by 50 basis points late September—its fourth straight increase—in its efforts to quell inflation.

MPC member Ashima Goyal voted to increase the repo rate by 35 basis points, while Jayanth R Varma had voted against the stance.

The economic activity is steadily improving, but there are mixed signals, cautioned RBI Governor Shaktikanta Das. While high-frequency indicators are showing continued momentum in activity, global factors are putting pressure on external demand, he said.

"I remain optimistic about the future prospects of the Indian economy, its resilience and capacity to deal with the current and emerging challenges," Das said. "We need to do whatever is necessary and under our control to restrain broadening of price pressures, anchor inflation expectations and contain second round effects."

It is important to note that even though the policy rate has moved to pre-pandemic levels, the overall monetary conditions taking into account the liquidity position and the inflation remain accommodative, Das said.

"Monetary policy needs to remain watchful and nimble, based on incoming data and evolving conditions."

"We should remain vigilant on the inflation front while strengthening our macroeconomic fundamentals," he said. The financial and external sectors also continue to be under the RBI’s close watch. "In the final analysis, there is optimism and confidence around the India growth story and our current action is expected to add credence to that narrative," said Das.

Although supply shocks appear transitory at this juncture—barring energy prices which will be shaped by the evolving geopolitical situation—it is critical to remain watchful about second-order effects if the shocks persist or recur, said RBI Deputy Governor Michael Patra.

"What is disquieting, however, is that inflation stripped of these transitory effects has become unyielding and tightly range-bound around the upper tolerance band of the inflation target."

Inflation expectations are rising, with signs that they are becoming unanchored over a one-year ahead horizon, he said. Taken together with a closing output gap, rising capacity utilisation in manufacturing, surging demand for services and the pickup in spending as the festival season nears, monetary policy must move to red alert, he said.

In this context, front-loading of monetary policy actions can keep inflation expectations firmly anchored and balance demand against supply so that core inflation pressures ease, Patra said. It will also reduce the medium-term growth sacrifice associated with steering inflation back to target because it is being timed into the strengthening of the recovery of the domestic economy that is underway and likely to gather further momentum as the year progresses.

"In a scenario where growth momentum gains further traction and inflation pressures are projected to remain elevated over the remaining part of the year, before registering a moderation by Q1 FY24, monetary policy has to persevere with its exit from accommodation to ensure that calibrated policy rate hikes dampen inflation expectations and firmly establish our commitment to price stability," said RBI Executive Director Rajiv Ranjan.

This would help achieve the optimal mix of growth and inflation which will set the foundations for a high growth trajectory over the medium term, he said.

The MPC should now raise the policy rate to 6% and then take a pause, said Jayanth R Varma, member of the MPC. A pause is needed after this hike because monetary policy acts with lags, he said. It may take three-four quarters for the policy rate to be transmitted to the real economy, and the peak effect may take as long as five-six quarters.

"If we raise the repo rate to around 6% at this meeting, that would be a cumulative increase of around two percentage points in the space of just four months," Varma said.

The full magnitude of monetary tightening would be well over 250 basis points, he said. Much of the impact of this large monetary policy action is yet to be felt in the real economy. In fact, much of the policy rate action is yet to be transmitted to even the broader spectrum of interest rates.

"All this means that it is too early to know whether the policy action so far is sufficient or not." It may well turn out that even more monetary tightening is required, but it does make sense to wait and watch to see whether a repo rate of around 6% is sufficient to glide inflation back to target, he said.

"If we were to continue to tighten without a reality check, we would run the risk of overshooting the repo rate needed to achieve price stability," Varma said.

If the lagged effects of monetary policy are large—as in India—overreaction can be very costly, Goyal said.

"Harmful effects become clear too late and are difficult to reverse. Gradual data-based action reduces the probability of overreaction," she said.

"Both RBI and SPF (Survey of Professional Forecasters) headline forecasts imply the real rate will be approximately 0.75% with the repo rate at 5.75%. This is almost one, and can exceed unity if the fall in inflation is larger."

Goyal cautioned that this could be dangerous if growth slowed.

The MPC has to focus on the six-month to one-year-ahead real rate, as this is the horizon where monetary policy will have its greatest impact, she said.

According to external member Shashanka Bhide, there are significant uncertainties over the trajectories of growth and inflation.

To align the inflation expectations with the policy target rate of inflation, further increase in policy rates is necessary at this juncture, he said.