MPC reflects RBI cautiously navigating market interconnections

The RBI’s status quo on the ‘policy rates and stance’ continue to reflect the long-term structural challenges faced by India, notably high inflation, high fiscal deficit, and dwindling financial savings of the household sector

The history of monetary policymaking shows that the central bank’s autonomy plays a critical role in protecting price and financial sector stability, which are conducive to sustainable economic growth. By neither changing the policy stance nor the policy rates amid raised noises from the commercial and political circles, the Reserve Bank of India (RBI), on December 6, demonstrated its unwavering commitment to achieving the inflation target, and proved its operational autonomy.

To set the context for today’s policy decision, the RBI and the government agreed in 2015 on a policy framework that stipulated ‘price stability’ as the primary objective of monetary policy while keeping in mind the objective of growth. Subsequently, the Flexible Inflation Targeting (FIT) framework was adopted in 2016 by amending the RBI Act, 1934, to provide a statutory basis for a FIT framework.

To control the price rise, the government, first in 2016 and again in 2021, gave a mandate to the RBI to keep the retail (CPI) inflation at 4% with a margin of 2% on either side for a five-year period. This clear definition of a monetary policy goal has made the RBI more accountable as compared to the earlier times when it had to deal with multiple objectives.

It is pertinent to see the economic pressures faced by the RBI at the moment that have the potential to impact India’s macro-financial stability.

• India’s headline CPI inflation (the nominal anchor of monetary policy) has crossed the RBI’s upper tolerance level of 6% after 15 months in October, driven by exceptionally high vegetable prices and some uptick in core inflation after a long gap.

• A deep statistical analysis done by some noted economists shows that there are larger and more frequent swings in food prices with shorter durations in the past two-three years. This is observable across the board at all horizons (two-years, one-year, six and three months). One needs to understand the fundamental causes for the changed price behaviour to announce a well-informed policy.

• A deceleration in economic growth in recent months is not as serious as the sharp upsurge in retail prices and increased variability of retail inflation. Moreover, the increased volatility of inflation has been adversely impacting the investment and consumption confidence.

• Recent months have seen a significant strengthening of the US dollar, affecting investors and businesses worldwide.

• Thanks to the RBI’s prudent and practical forex strategy, India had created a rich foreign exchange reserves’ buffer that reached $705 billion as of September 27. However, Between September 27 and November 22, India’s foreign exchange reserves were depleted by $48 billion. A sizeable portion of this was likely to be sold by the RBI to ensure an orderly depreciation of the rupee. Despite the RBI’s repetitive forex interventions, the rupee depreciated by nearly 1% during this period.

Against this backdrop, the policy tweaks effected by the RBI on December 6 are quite interesting. Without changing the policy stance or policy rates, the RBI has reduced the Cash Reserve Ratio (CRR) of all banks by 50 basis points (bps) to 4% in two equal tranches on December 14 and December 28. This will release the primary liquidity of about Rs 1.16 lakh-crore to the banking system, partially compensating for the RBI’s forex intervention to stabilise rupee.

When the RBI intervenes in the forex market by selling US dollars, it sucks out rupee liquidity from the banking system. The CRR change has brought it back to the pre-tightening level, i.e. before April, 2022.

As the RBI has already sucked out significant amount of rupee liquidity from the banking system in the last two months due to its forex interventions, returning part of the liquidity to the banking system does not harm its ‘neutral’ policy stance. On the contrary, it supports the seasonal uptick in credit demand usually seen in the second half of any financial year.

As economists know, there are difficult policy issues in the interaction between capital inflows, monetary policy, and the exchange rate. These interactions create many challenges for monetary policymaking. By restoring the CRR to its pre-tightening level, the RBI has influenced the money market interest rates in the short-term. However, its status quo on the ‘policy rates and stance’ continue to reflect the long-term structural challenges faced by India, notably high inflation, high fiscal deficit, and dwindling financial savings of the household sector.

(Rupa Rege Nitsure is a former Chief Economist from the BFSI Sector)