What explains the divergence between the RBI and govt on monetary policy?

One, high inflation changes consumer behaviour: if prices are rising fast, it makes sense to buy things today rather than wait for tomorrow. But when everyone — or at least a large number of people — starts behaving like this, it only stokes inflation further. Prices rise faster because everyone starts demanding goods today even when they do not need them.

Two, high inflation also changes producer behaviour. If the price of inputs rise fast, it can eat into the producer’s profitability. If the producer passes on the higher prices to consumers — and not every producer is in a position to do that — it can bring down the demand for the product, and they can lose crucial market share that took years, even decades to build.

Moreover, if prices rise fast, it is difficult to plan future production. That is because the producer remains unsure of the supply and demand situation. A producer could lose heavily by over producing; but they can also lose out by cutting production.

As such, maintaining price stability is critical to sustaining fast economic growth.

The key thing to remember is that measures that the Reserve Bank of India (RBI), which is responsible for maintaining price stability, takes to contain inflation, also slow down economic growth. For instance, raising interest rates, which is the most common and fundamental tool to contain inflation, makes it costlier for consumers to borrow and consume and for producers to borrow and produce — thus slowing down overall economic activity.

By a similar logic, when RBI wants to promote growth, it reduces interest rates, thus giving a boost to credit-driven consumption and production.

What is the actual situation in India right now?

Under normal circumstances, high inflation happens as a result of high growth — i.e., people producing more, buying more, earning more, etc. In such a scenario, even though tamping down on high inflation drags down growth, the situation remains manageable because the economy still continues grow, albeit not as fast.

But what if the inflation becomes high at a time when economic growth is faltering?

This is one of the worst scenarios for policymakers. That’s because measures to contain inflation — such as raising interest rates — now risk running the economy aground.

This is exactly what is happening in India.

India’s GDP growth rate had been decelerating sharply over the three years leading up to the Covid-19 pandemic. It decelerated from more than 8% in 2016-17 to less than 4% in 2019-20.

By late 2019, inflation started creeping up. Then, in March 2020, came the Covid-induced nationwide lockdown. It was one of the strictest lockdowns anywhere in the world. What’s worse, it was sudden and completely unplanned, and as a result, created massive disruption.

Almost instantly, India’s faltering GDP came to a standstill. The economy started contracting. The RBI responded by cutting interest rates sharply in order to limit the economic contraction and continued to stay put in order to fuel the recovery.

The trouble was, inflation never gave up. It continued to stay above the RBI’s target rate of 4% for many months. This trend worsened in May 2021, when it started staying outside RBI’s comfort zone of 6%. RBI continued to ignore this inflation because it was prioritising economic recovery and did not want to stall it. Between May 2021 and March 2022, inflation stayed around or above 6%.

Then came the impact of the war in Ukraine. It sent inflation beyond 7%. In April 2022, inflation hit the 7.8% mark — the highest it had been since Prime Minister Narendra Modi took office in 2014. Since then inflation has stayed around 7% every month.

Why is there a divergence between RBI and the government?

From May 2022 onward, the RBI started raising the interest rate because by then it was clear that inflation could no longer be ignored, and that, if not contained, it would undermine India’s economic recovery. It is noteworthy that the RBI’s main legal mandate is to maintain price stability. It must, by law, keep inflation at 4% with a leeway of two percentage points either side in any particular month.

But then, these actions by the RBI — and more rate hikes are in store — will drag down economic growth. And that is where the government is concerned.

With less than two years left for the next general elections in early 2024, the government is struggling to deal with massive and widespread unemployment. While in percentage terms GDP growth rates look rosy, the truth is that in real terms the economy is barely out of the contraction it witnessed during the Covid pandemic.

Unemployment has been a concern since 2017, when it hit a four-decade high. What is worse is that economic growth is unable to create the jobs the  government had hoped it would. By itself, the government cannot start creating jobs because it also has a budget constraint; in fact, it is already failing to meet its prudential norms — the so-called Fiscal Responsibility and Budget Management  (FRBM) Act.

So, here’s the essential problem: If RBI continues to tighten monetary policy, it will weaken economic recovery at a time when growth is already faltering and unemployment is already quite high. If RBI ignores inflation then it hits the poor immediately without necessarily guaranteeing that growth and unemployment will be resolved.