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Saturday, September 25, 2021

ExplainSpeaking: Decoding the RBI’s monetary policy stance

RBI’s upward revision of inflation and downward revision of economic growth have wide-ranging policy implications

Written by Udit Misra , Edited by Explained Desk | New Delhi |
Updated: August 14, 2021 3:13:38 pm
Reserve Bank of India Governor Shaktikanta Das. (Express Photo: Prashant Nadkar, File)

Dear Readers,

Last week, the Monetary Policy Committee (MPC) of India’s central bank, the Reserve Bank of India, met and decided that it would neither increase nor decrease the benchmark interest rates in the economy. In fact, it did not even change its “stance” (or the approach to making policy decisions). But there was much activity behind this apparent inaction on the part of the RBI.

Let us first understand the context in which this policy was being announced.

As explained in last week’s ExplainSpeaking, every two months, the RBI evaluates the outlook on economic growth and inflation. For inflation, it has a well laid out target — maintaining retail inflation at 4% with a leeway of 2 percentage points on either side. In other words, retail inflation can vary between 2% and 6% without the RBI needing to explain to the Parliament. On growth, there is no specific target. In fact, RBI (or for that matter any central bank) cannot actually “target” a particular level of GDP growth. All it can do is to “prioritise” supporting growth as against containing inflation.

Since late 2018, when Shaktikanta Das took over as the RBI Governor, the RBI has been prioritising supporting growth over curbing inflation. This strategy involved signalling a cut in the interest rates prevailing in the economy; the RBI does this by cutting the repo rate, which is the rate at which it lends money to the banks. This strategy was possible because retail inflation had been well within the RBI’s comfort zone.

But since late 2019, retail inflation has been either almost 6% or more. This, in turn, incapacitated the RBI to cut interest rates further — even when a Covid-induced “technical” recession demanded the RBI to do whatever it could.

Unable to cut rates itself, the RBI did the second best thing: Flood the market with lots of money (often referred to as liquidity). It hoped that this would enable borrowers — be it small businesses or large companies or indeed the Government of India — to raise funds at a time when most revenue sources had dried up.

But excess liquidity in the market also fuels inflation, which was already running quite high. Moreover, data shows that the banks have parked a large part of these funds back with the RBI. The banks do this using the “reverse repo rate”. It is the interest rate that banks earn when they park their money with the RBI. Like with any other bank, RBI’s repo rate is higher than its reverse repo rate. In fact, thanks to the massive surge in liquidity, the reverse repo has become the real benchmark interest rate in the economy. Read this explainer to know more.

Why were the funds lying unused?

This happened for two reasons. One, thanks to enormously high levels of non-performing assets (NPAs or “bad” loans or loans that did not get repaid), banks have become quite risk-averse and, as such, did not want to extend new loans at a time when they are not sure if the borrower will be able to repay them. Two, the overall credit demand among businesses is at a historic low because they do not see any reason to invest in new capacities; most are already saddled with unsold inventories.

So, as the six-member MPC of the RBI came to deliberate on the policy, it was faced with two challenges: anaemic growth and rising inflation. The key questions before the RBI were: Should it raise the repo rate to curb inflation or should it continue to keep them down in a bid to support economic recovery? [Cutting interest rates wasn’t an option since inflation has been quite high for a while.] Similarly, should it start sucking out some of the excess liquidity from the market? Should it change its “stance” from being “accommodative” (of growth) to “neutral”?

In the end, the RBI did three main things. One, it stayed put with the repo rate. Two, it opened up the window to suck some money out of the market via the reverse repo window. Three, it retained its stance as “accommodative” but, unlike in the recent past, this time the decision was not unanimous.

Let’s unpack why these decisions were taken and what are the implications.

On Inflation

This is the primary responsibility of the RBI. And the news is not good. On the back of high retail inflation — the last two data points for May and June were over 6% — the RBI has increased its forecast for inflation. The next retail inflation data (for July) is expected this week. See the table below (Source: CARE Ratings). The highlighted bits show how RBI has revised upwards the inflation forecast it did during the last policy review in June.

RBI’s Outlook August’21

While the expectations of higher inflation rule out an interest rate cut (aimed at boosting growth), they do have other very serious policy implications.

One, the most worrisome aspect of high levels of inflation (which is the rate at which prices rise) in India this year is that the current price rise is on the back of high inflation last year. Further, as the data shows, the RBI expects another 5.1% increase in prices in the first quarter of the next financial year. Worse still is the fact that this price rise is happening when the overall demand in the economy is still quite depressed; as and when demand picks up, inflation will likely rise further.

Two, for each passing month that inflation stays high, fewer people are convinced by the RBI’s contention that this streak of high inflation is just a passing (or “transitory”) phenomenon. To be sure, this is not just a matter of academic quibbling. If most Indians do not believe that the current bout of inflation is transitory then their expectations of future inflation will “harden”. In other words, they would strongly believe that inflation will remain high in the future as well. This, in turn, will likely change their behaviour. For instance, if people expect inflation to be higher next year, it will likely affect what they demand as wages. This demand, in turn, will affect the pricing decisions of the firms that employ people because businesses would like to shift the cost of higher salaries onto the consumers. But doing that will only increase the price level further. It is for this reason that it is important for any central bank to “anchor” inflation expectations. And the best way to do that is to hold back inflation from staying too high for too long.

Three, if inflation does not come down, the RBI will be forced to raise interest rates either by December 2021 or February 2022 policy reviews.

It is important to note that the RBI’s decision to avoid raising interest rates is helping all the borrowers (such as the Government of India and the biggest businesses) in the economy.


High inflation reduces the real rate of interest (calculated as nominal interest rate minus inflation rate) to be paid on one’s loans.

But this stance of the RBI hurts the poor — who are the hardest hit by inflation (which is nothing but the most regressive kind of taxation) — as well as the lenders and depositors because their bank savings are effectively losing value each year (by 2% if the interest that they earn is 4% and the inflation rate in 6%).

Four, the persistence of high inflation — RBI expects retail inflation to be 5.1% in the first quarter (April to June) of 2022-23 — means that the government can no longer expect the RBI to do the bulk of the work to boost economic growth. Instead, the government will have to accept that the primary responsibility to boost GDP lies with it, and not the RBI, which has done everything it could to support recovery.

On Economic Growth

On the face of it, the RBI’s latest forecast for GDP growth in the current financial year is the same — 9.5% — as it was in the last policy review in June. But there is a crucial difference (see the highlights in the table below). The RBI has dialled down the GDP growth estimates for each of the three remaining quarters in 2021-22.

RBI’s Outlook August’21

If India’s economic recovery had been robust then the RBI could have focussed single-mindedly on curbing inflation. But as these revisions show, the RBI still considers the recovery to be quite anaemic and it suspects that raising interest rates at this juncture (to curb inflation) may hurt the fledgling economic recovery.

“Since the start of the pandemic, the MPC has prioritised revival of growth to mitigate the impact of the pandemic. The available data point to exogenous and largely temporary supply shocks driving the inflation process, validating the MPC’s decision to look through it. The supply-side drivers could be transitory while demand-pull pressures remain inert, given the slack in the economy. A pre-emptive monetary policy response at this stage may kill the nascent and hesitant recovery that is trying to secure a foothold in extremely difficult conditions,” said the RBI Governor in his statement.

On RBI’s policy overall stance

In every policy, the RBI announces (or reiterates) its stance. The stance provides guidance to everyone in the economy on what the RBI is trying to achieve. Monetary policy is most effective if it is transparent and predictable.

Much like the announcement on GDP growth, the RBI’s stance did not change. The RBI stated that it maintains its “accommodative” stance. In other words, it will continue to be in the mode where it will do “whatever it can” to support growth.

But the fine print revealed a crucial change. Unlike the recent past when all six members of the MPC were behind this decision unanimously, this time around there was one dissenting voice.

The lack of unanimity points to the growing dilemma — between containing inflation and supporting economic growth — faced by the RBI.

If inflation stays high then regardless of how iffy the recovery is, one should not be surprised to see more difference of opinion among the MPC members.

What makes this more likely to happen is the fact that the RBI has been underestimating inflation and overestimating growth in the immediate past. See the table below (source: SBI) which provides how RBI’s estimates for growth and inflation have changed for each of the quarters between April, June and August policies.

RBI’s growth and inflation outlook for India

Another reflection of the growing inflation threat has been the decision by the RBI to suck out some liquidity using the reverse repo window. As a general principle, a higher reverse repo rate will incentivise banks to park more funds with the RBI, thus reducing the liquidity in the market.

Should the government take the lead in boosting GDP growth and leave the RBI to focus on curbing inflation? Write to me at to share your views and queries.

Stay safe,


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