Oil prices are not the real policy challenge for countries like ours

News: The US Federal Reserve has raised its federal funds rate by another 75 basis points to tame inflation. The Reserve Bank of India (RBI) has also raised its policy rate, including an inter-meeting rate hike.

Inflation Forecasts

Recently, India’s inflation forecast has been revised from 4.5% to 6.7% in a span of a few months.

What are the reasons for inflation forecast revision?

A major geopolitical conflict that broke out in early 2022 has led to upending of the inflation forecasts globally. Therefore, the RBI was also compelled to take this into account for the inflation forecast.

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 ours.

Why is the RBI being criticized?

RBI has set the upper bound as the central inflation target. It is being criticized for prioritizing growth over its inflation mandate in the last few years which has led to the present inflationary pressure situation.

Why is the RBI’s criticism not correct?

(A) In the last few years, the Indian economy has faced successive shocks in the last few years. There were

(1) The balance sheets of the financial and non-financial sector had to be repaired substantially over the last decade after the credit excesses of the previous boom.

(2) There was a collapse of a large non-banking financial company and housing finance companies.

(3) Thereafter, India has also faced the brunt of the pandemic or the lockdown induced economic slowdown.

(B) It has to be understood that the RBI was not prioritizing growth so much as it was ensuring macro stability.

What is the appropriateness of an inflation-targeting regime?

Monetary policy is a short-run aggregate demand management tool. It is not the right instrument to address supply-side induced inflation. The central banks have a limited role and effectiveness in dealing with supply-side inflation

The central bank can be blamed for not suppressing demand and economic growth because demand compression is a valid policy option until supply-side problems are not fixed. It will alleviate pressure on supply and cools down prices.

The monetary policy has asymmetric effectiveness. It cannot generate inflation by itself (unless aided by fiscal stimulus and other real factors). But it can be effective in taming inflation. This is because there is no cap on how far rates can rise.

What are the other challenges?

The US Fed is raising interest rates. It endangers macroeconomic and financial stability in emerging economies.

The US Fed is doing monetary tightening after a long period of extraordinary accommodation.

Way Forward

At present, the central banks must focus on broader macro and financial stability, of which inflation is one part

In the current global context, the RBI’ monetary policy normalization is important to ensure macro and financial stability, orderly conditions in capital markets and normal evolution of the external value of the currency. It will ensure financing a considerably large current account deficit without disruption.

Source: The post is based on an article “Oil prices are not the real policy challenge for countries like ours” published in the Live Mint on 17^th June 2022.