'Here Comes The Sun': The RBI's Tagline For Its Repo Rate Hikes
What does the RBI seek to achieve with the recent monetary policy action? The central bank explains.
Inflation is getting out of control. Now what?
"Here comes the sun—monetary policy."
[The RBI's words, not ours.]
The RBI’s actions will cause core inflation, excluding food and fuel, to ease and bring down headline inflation, the central bank said explaining the rationale behind the recent benchmark repo rate hikes.
"It is worthwhile to communicate with clarity as to what the RBI seeks to achieve with the recent monetary policy action," the central bank said in its monthly bulletin for June published on Thursday. The idea is to share with the public a common set of expectations so that monetary policy serves as an anchor for the Indian economy, it said.
There is no doubt that the first impact of a food and fuel price shock to inflation lies outside the realm and remit of the RBI, especially with food and fuel prices constituting 60% of the CPI and the food shock emanating from the war in Europe in this case, it said. But what happens next?
Households’ inflation expectations tend to be backward looking, the central bank explained. They tend to look at recent food and fuel prices and they form their opinion about what inflation would be in the future. If households believe that inflation will go up and stay up, they are in effect saying that it is better to prepare for that difficult situation, it said.
As households and firms increasingly share this view, they will build it into price mark-ups, wage negotiations, rents on houses, transportation costs and the prices of services, more generally such as personal services like housekeeping, medical and education fees, entertainment and bus, train and auto fares, according to the RBI. With households accounting for two-thirds of India’s GDP in the form of private consumption expenditure, this will mean that inflation will become entrenched in the Indian psyche, and will become persistent and generalised. This, RBI said, would imply an adverse outlook for the economy.
Businesses will stop investing, wages and costs will go up, export competitiveness will be damaged and savings in banks will be pulled out and put into assets like gold, which means capital flight from India since 98% of gold demand is met from abroad for which foreign exchange has to be paid, it explained.
"Inaction by the Reserve Bank will be seen as accommodating the inflation shock and such a perception may lead to a belief that inflation is getting out of control."
On the other hand, if it increases interest rates and tightens monetary and liquidity conditions, it will demonstrate that the RBI cares about people’s expectations, anchor inflation expectations, prevent the second round effects of food and fuel prices from getting entrenched, and deter discretionary spending so that even if people’s spending on food and fuel goes up because of the price shock, they will adjust their expenditure on other items which will have a moderating impact on overall inflation, the central bank said in it's bulletin.
The RBI is trying to stabilise the price situation when the economy is able to bear it because in the longer run, price stability is beneficial for growth, it explained.