RBI’s tightrope walk amid policy shifts

On April 9, the Reserve Bank of India (RBI)’s Monetary Policy Committee decided to reduce the policy repo rate by 25 basis points to 6% — its second consecutive rate reduction after a similar move on February 7 — to support growth amid amicable headline inflation and global uncertainty.

However, the risks to the headline inflation in the medium term are tilted to the upside against the backdrop of fiscal stimulus, volatile oil prices, supply shocks arising from disruption in the supply chains amidst trade tensions, and geopolitical fragmentations due to ongoing conflicts, necessitating a careful relook at adoption of a more aggressive monetary policy.

The theoretical underpinnings of the Phillips curve imply that there is an inverse relationship between the level of unemployment and the rate of inflation in the short run. The conventional monetary policy theory of steady correlation between inflation and the output gap further underscores that inflation is closely associated with the frail economic conditions arising out of the persistence of unemployment and resultant low level of demand. The 2024 periodic labour force survey reveals tiny gains in generating widespread employment opportunities in India that year.

The unemployment rate under the principal and subsidiary status rose from 3.1% to 3.2%, indicating joblessness in the long run. Similarly, the worker population ratio (WPR) during the same period declined from 58% to 57.7%, further suggesting a moderation in employment in 2024. The decline in the growth rate of employment could have led to a reduction in the purchasing power of the people and, eventually, to a lower level of aggregate demand in the economy. This interconnectedness between unemployment and inflation, in the context of the Phillips curve, could have had positive implications for headline inflation and served as a boon in reducing it.

The recently released headline inflation data indicates that the continuous decline in the price level in the past couple of months was mainly a result of a low level of food inflation. The consumer food price index (CFPI) declined to 1.78% on a y-o-y basis in April; however, it should also be noted that one of the reasons for such a decline in the food prices could also be a high level of the base during the previous year, where the food inflation was recorded at 8.7%. Besides, it is estimated that the core inflation, which is arrived at after removing the volatile items such as food and energy prices from the headline inflation, is still hovering in the range of 4%-4.1%, suggesting that prices continue to pinch consumers across other major components.

The official GDP estimates released on February 28, estimated a marginal increase in the share of Private Final Consumption Expenditure (PFCE) in real GDP from 56.1% in 2023-2024 to 56.7% in 2024-2025. However, there has been a sharp rise in the revenue collection from the GST to the tune of Rs 2.37 lakh-crore in April, which is an increase of 12.6% as compared to the previous year. Besides, the growth rates in the GST revenue observed in the past few months were in the range of 10%-12%. The subdued growth in the private consumption demand juxtaposed with a persistent rise in the revenue collection from the GST indicates the underlying inflationary pressures in the economy, particularly when the higher indirect tax revenues in the form of GST stem from the lower consumption volumes.

The expansionary fiscal policy measures introduced in the Union Budget 2025-2026 in terms of reduction in personal income tax, emphasis on capital expenditure, sector-specific incentives in terms of easy credit particularly to MSMEs, among others, are further expected to increase the aggregate demand in the economy, and have the potential to hinder effective inflation management.

Similarly, volatile international oil prices pose a perennial and credible threat to inflation through imported inflation. The fuel and light inflation rose steadily from -1.33% in February, 1.48% in March, to 2.92% in April on a y-o-y basis, recording an increase of 7.16% over April 2024.

Additionally, the potential failure to negotiate beneficial trade deals with trade partners could lead to inflationary pressure arising from demand and supply shocks.

Despite the recent success in containing headline inflation within the mandated target of 4% (±2%) set out in the FIT framework, challenges such as inadequate employment generation, dwindling growth prospects, climate change, the vagaries of the Monsoon, and global uncertainty, inter alia, still persist. In this context, it is worthwhile to note that the aggressive accommodative monetary policy may exacerbate the risks to medium-term price stability. The MPC must resist more aggressive rate cuts of 50-75 basis points to be in a better place to withstand any adverse repercussions that could threaten price stability.

(Chinmay Joshi is a Research Associate, Economics and Policy department, Bharatiya Vidya Bhavan’s S P Jain Institute of Management and Research (SPJIMR), Mumbai. Views are personal.)

Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.