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Inflation Targeting Vs Growth – way forward for RBI

Inflation Targeting Vs Growth – way forward for RBI

UPSC CSE Mains Syllabus -GENERAL STUDIES-3-Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.

Inflation Targeting Vs Growth – way forward for RBI

The current macroeconomic backdrop offers little comfort for the newly-constituted Monetary Policy Committee (MPC) ahead of their meeting that began today.

Not only did economic activities record an unprecedented 24 per cent year-on-year (YoY) contraction during the first quarter of the financial year, further contractions in GDP during the remaining quarters of the financial year cannot be ruled out as well.

Near-failure in inflation targeting:

  • On the other hand, retail inflation prints have been materially above RBI’s comfort zone in recent months.
  • Current CPI prints may not allow space to cut rates immediately.
  • The headline CPI prints are set to average above RBI’s “upper tolerance level” of 6% for three consecutive quarters ending September.
  • India’s prevalent inflation targeting framework suggests that if the average inflation is more than the upper tolerance level of 6% (or less than the lower tolerance level of 2%), for any three consecutive quarters, it would mean a ‘failure’ to achieve the inflation target.

What it has do:

  • In such a situation, the central bank is supposed to send out a report to the central government stating the reasons for the failure to achieve the inflation target.
  • It should also propose remedial actions along with an estimate of the time period within which the inflation target shall be achieved pursuant to timely implementation of the proposed remedial actions.

Complex situation:

  • Since the adoption of the inflation targeting framework in 2016, this is the first time that RBI is facing such a situation.
  • While treating April and May as a break in the CPI series may exempt the central bank from the obligation of sending out the report as discussed above, undoubtedly, the headline inflation prints remain a concern for the MPC.
  • Thus, the possibility of a rate action at the October MPC meeting is low despite the severe GDP contraction.

Nature of inflation:

  • However, the upside surprise in retail inflation in recent months was driven largely by supply disruptions in various parts of the country and was certainly not due to any overheating of demand.
  • While even the core inflation prints were high, items such as precious metals made a meaningful contribution.
  • While that may prevail in the coming months, one believes the MPC will continue to differentiate between inflation emanating from such factors and demand-pull inflation while formulating policy responses.
  • Also, other indicators such as wholesale price inflation (WPI) remain markedly low, underscoring the supply disruptions behind the surge in CPI rather than excess demand.

Conservative vs Accommodative stance:

  • Furthermore, monetary policy has to be forward looking.
  • Despite the upside surprise in recent months, the estimate is that CPI inflation will likely be around 4 per cent or lower during a sizeable part of H2 of FY20-21.
  • Thus, it is important for the MPC to keep supporting economic recovery.
  • RBI has been forthright in supporting the pandemic-hit economy in recent months and one expects such priorities to prevail.
  • Against such a backdrop, on balance, while MPC’s hands seem to be tied at present given the near-failure in meeting its inflation target, one believes RBI is not done with rate cuts.
  • While a status quo in policy rates is likely in October, expectation is that the continuation of an ‘accommodative’ stance and further rate cuts later during FY20-21 even from current historic lows.

Economic growth contraction:

  • Indeed, recovery in economic activities remains slow, uneven and uncertain.
  • RBI’s latest Financial Stability Report, released in July, and indicated the central bank’s baseline expectation of a mid-single digit contraction in GDP during FY 20-21.
  • However, the odds favouring a near double-digit contraction during this financial year seem to be rising, even after taking into account improvements in high frequency indicators such as PMIs, electricity demand, traffic movement and core industrial growth.

What is needed:

  • Given the importance of fiscal spending to support economic activities, eventually a larger quantum of government borrowing is on the cards.
  • Thus, RBI would continue providing support to the bond market.
  • RBI has already allowed greater flexibility for the held-to-maturity (HTM) books of banks.

Central Bank may consider,

  1. elongating the maturity profile of government’s liabilities, especially given the current low interest rates
  2. issuing larger quantum of securities in the benchmark 10-year bucket to ensure better liquidity in this segment, apart from
  3. stepping up OMO purchase during H2 FY 20-21.
  4. Furthermore, targeted liquidity operations – like the TLTROs that RBI offered this summer – can play a key role in providing focused support to various sectors of the real economy, including the lower end of the economic pyramid such as microfinance, MSMEs and affordable housing.

These segments have started exhibiting signs of turning a corner, and can attain further resilience and growth with meaningful and targeted policy support.

Relatively modest targeted liquidity support in these areas cannot only have the potential to immediately offer a cushion to a large number of people at the relatively less privileged segments of the society, but also reduce the need for further fiscal support for these segments over the medium term.

Source: ”Economic Times”.


Reserve Bank of India is facing a complex situation as inflation has been rising but growth is contracting. Discuss the various measures that it could take to combat them.