The US Federal Reserve has raised its federal funds rate by another 75 basis points. It appears on course for an encore in July. Given its determination to tame inflation, it is good that the Reserve Bank of India (RBI), despite a slightly later-than-desirable start, has displayed resolve in raising its policy rate, including an inter-meeting rate hike. Some have called its inflation forecast revision for India from 4.5% to 6.7% in a span of a few months a sign of flying blind. There is another way of looking at it. Having realized that its inflation forecast was out of line with emerging reality, RBI wasted no time in raising it. That shows intellectual openness. Second, we should recall that the consensus forecast of professional forecasters in 2022-23 was 5.0% while RBI’s was 4.5%. Not much of a difference. Third, there is the minor detail of a major geopolitical conflict that broke out in late February that upended inflation forecasts globally; so blaming RBI for a mis-forecast is a bit rich.
Criticisms that RBI has been remiss in meeting its inflation target and treating the upper bound as its central inflation target miss the point of our economy having weathered successive shocks. Financial and non-financial sector balance sheets had to be repaired substantially over the last decade after the credit excesses of the previous boom. Then, there was the collapse of a large non-banking financial company and housing finance companies that compounded the banking sector’s balance sheet adjustment of the time. As the dust was settling, came the pandemic. To ignore these shocks and criticize RBI for prioritizing growth over its inflation mandate is to be churlish and miss the wood for the trees. It was not prioritizing growth so much as it was ensuring macro stability.
Then, questions have arisen about the appropriateness of an inflation-targeting regime. It is amusing that in some circles, RBI’s approach to inflation is questioned when it becomes mindful of it, and in others, it is questioned when it is not mindful. The central bank must do what it thinks is right and be able to do it too.
The question of whether monetary policy is the right instrument to address supply-side induced inflation is an age-old one. Monetary policy is a short-run aggregate demand management tool, as per textbooks. But extended ultra-loose policies in advanced countries since 2008 until recently, in contravention of this idea, have been behind most global asset price inflation for quite some time and goods price inflation woes recently. For this, developing countries like India are having to face the music.
In addressing supply-side inflation, central banks have an unenviable task. They will be blamed for suppressing demand and economic growth when demand isn’t the source of inflation. But until supply-side problems are fixed, demand compression is a valid policy option. To the extent that demand in interest-rate sensitive sectors is dampened by rate hikes, it alleviates pressure on supply and cools down prices. Second, yours truly had written enough in the past about the asymmetric effectiveness of monetary policy. It cannot generate inflation by itself (unless aided by fiscal stimulus and other real factors, as has happened in the last 18 months), but can be effective in taming inflation since there is no cap on how far rates can rise.
However, even if these arguments are unconvincing to some and they feel that central banks have a limited role and effectiveness in dealing with supply-side inflation, then there is the question of macro-economic stability when other central banks, especially the US Fed, are raising interest rates. That endangers macroeconomic and financial stability in emerging economies. When the Fed gets serious about monetary tightening, and that too belatedly after a long period of extraordinary accommodation, there are inevitably major asset market corrections as risk aversion rises and the dollar strengthens. Capital flows dry up. Countries that have an external deficit to finance must be very mindful of that, whether such spillovers are fair or not.
Even those of us, like yours truly, who believe that central banks must focus on broader macro and financial stability as their remit, of which inflation is one part, will agree that in the current global context, monetary policy normalization in India has a role in ensuring macro and financial stability, orderly conditions in capital markets and normal evolution of the external value of the currency, so that a considerably large current account deficit can be financed without disruption.
Nations that tried to experiment with monetary policy in these times are seeing very high inflation. To paraphrase Benjamin Franklin, they sacrificed macro and price stability for growth and ended up with neither.
V. Anantha Nageswaran is chief economic advisor to the Government of India
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