The monetary policy committee should slow its pace of tightening

Source– The post is based on the article “The monetary policy committee should slow its pace of tightening” published in Live Mint on 16th November 2022.

Syllabus: GS3 – Economy

News- The article explains monetary policy related matters.

What is the present Monetary Policy stance?

Indian monetary policy easing began in early 2001.

The pace of easing quickened after the pandemic struck in early 2020. They have increased the benchmark repo rate by 190 basis points since May 2022. It is due to a recovery in economic activity which allowed policymakers to focus more on the challenge of rising prices.

Monetary conditions have also become tighter since the evaporation of excess liquidity in the money market.It was also led by a sharp fall in foreign exchange reserves.

Why should RBI follow the policy of modest interest rate hike?

It would signal that the battle against inflation is still not over.The MPC meeting in October has already revealed  how interest rate hikes in recent months have been curtailing domestic demand, rather than maintaining the recent pace of rate hikes.

Another argument  is that there is not enough evidence whether the spike in inflation has had significant second-round effects. It usually happens through either the labour market or corporate pricing power.

The Indian labour market still has slack, especially if we look at the labour force participation ratio rather than the unemployment rate. Wage growth is likely to be muted in such a labour market.

On the other hand, companies have greater pricing power now because of the multiple shocks to small and informal enterprises over the past five years.

How does Indian inflation compare with the price situation in other major economies?

The numbers show that the Western world is in the midst of full-fledged inflation shocks. They chose oversized stimulus packages during the pandemic

For reasons specific to each country, India, China and Japan are better off.

A good thumb-rule is that countries with greater distance from their inflation targets as well as past inflation need to react more strongly to price pressures. For example, the US has more reason to push its real interest rate beyond its estimated neutral interest rate than India does right now.

What is the way forward?

The Indian MPC needs to figure out whether it wants to use the interest rate solely to target inflation, or also use it to manage the exchange rate as well as financial stability.

Ideally, RBI should manage the exchange rate by using its foreign exchange reserves. But the sharp fall in its reserve during the recent defence of the rupee. It  means that the interest rate tool will have to be used for inflation control as well as curbing volatility of the exchange rate.