How the RBI unconventionally innovated policy to fight the pandemic

News: The RBI has been missing the inflation target since 2019 by not raising rates. This raised some debates about RBI’s inflation management.

What is the reason for rising inflation in India?

There are two reasons that inflation is on the rise. These are,

a) Inflation has been largely the result of supply-side shocks from vegetable prices, caused by crop damages due to unseasonal rains in late 2019, b) Widespread supply-side disruptions after the outbreak of the pandemic.

How does the RBI tackle inflation while ensuring growth?

The amended mandate of the RBI under the flexible targeting (FIT) framework reads as “price stability, taking into account the objective of growth”. Accordingly, the Monetary Policy Committee (MPC) was looking through higher inflation print during the pandemic while trying to resurrect growth. This is done through,

First, the MPC highlighted inflation concerns and voted to raise the policy repo rate. But, the RBI governor has ensured an orderly completion of the government’s borrowing programme.  This implies that lowering inflation and lowering government bond yields are contradictory objectives.

But, this basically ensures that the borrowing programme is completed seamlessly at low costs.

Second, MPC kept repo rates unchanged while the RBI changed the reverse repo rate during the pandemic. This means that the MPC lost its role in setting interest rates and so, its credibility.

Third, The RBI activated other segments of financial markets to keep the lifeblood of finance flowing as reduced demand and heightened risk aversion broke down the traditional credit channel of policy transmission.

Financial conditions were eased substantially by reducing the reverse repo rate, which lowered the floor rate of interest in the economy.

The mandate of the MPC is to control inflation for which the policy instrument is the repo rate, the RBI had used the LAF through changes in the reverse repo rate to alter liquidity conditions. The intent was to reactivate the credit channel by encouraging banks to explore opportunities for extending credit.

How RBI’s approach is different from the rest of the world?

Inflation-targeting countries, because of their sole focus on inflation, experience lower inflation volatility but higher output volatility. Higher output volatility entails a higher sacrifice ratio — the proportion of output foregone for lowering inflation.

For an emerging economy, the costs of higher output foregone against the benefits of lower inflation must always be balanced. This is because the potential output keeps on changing given the shift of the production function.

Developed countries, on the other hand, operate near full employment — therefore, sacrifice ratios are lower. As a result, smoothening inflation volatility is relatively costless for them.

Despite the existing targeting framework, the RBI did not get fixated on a one-point agenda, daring to look beyond the inflation print. If the RBI followed the advice of its critics by sticking to textbooks, then the Indian economy would have been in an entrapment today. Hence, it was necessary to provide a lifeline to the economy at that juncture by focusing on the recovery.

Source: The post is based on the article “How the RBI unconventionally innovated policy to fight the pandemic” published in “Indian Express” on 2^nd July 2022.