Recently released data reaffirms that inflation in India is much less of a problem now than it was a year ago, in part, thanks to the monetary policy stance of the RBI. But what is the right policy going forward? The answer is not obvious — perhaps not even to the RBI.
Over the past three years, India experienced high and persistent inflation. Between April 2021 and September 2022, the wholesale price index (WPI) inflation averaged 13 per cent, the highest in more than a decade, triggered by the pandemic disruptions and the Russia-Ukraine war. Surges in wholesale prices normally suggest “inflation in the pipeline” and indeed, they soon translated into high retail inflation. During the first three calendar quarters of 2022, consumer price index (CPI) inflation averaged 7 per cent. Even excluding the rise in food and fuel prices, core inflation still hovered above 6 per cent for nearly every month from May 2021 to March 2023.
The persistence of core price pressures implied that high inflation had become embedded in the system. It seemed as if inflation had become the Achilles heel of the Indian economy’s recovery from the pandemic. Since then, the inflation dynamic seems to have changed. Starting April 2023, wholesale price inflation turned negative. According to the latest data, headline CPI inflation fell to 5.1 per cent in January 2024, the lowest in three months. With this, inflation has now been within the RBI’s tolerance band of 2 to 6 per cent for five consecutive months. Even more striking, core inflation came down to only 3.6 per cent in January, its lowest rate since the start of the pandemic. While there is still some way to go before the target of 4 per cent can be achieved on a sustained basis, it now seems much closer than it did two years ago.
This remarkable achievement can clearly be attributed to two factors: RBI’s dogged pursuit of a tight monetary policy and the softening of commodity prices.
However, going forward, the conduct of monetary policy might get complicated owing to a set of puzzles. To understand this, we need to consider how monetary policy gets transmitted to the wider economy. Let’s revisit the basics.
When the RBI pursues contractionary monetary policy, it gets transmitted to the rest of the economy through financial intermediaries such as the banking sector. In response to the RBI’s hikes in the policy repo rate, banks promptly raise their lending rates and eventually, their deposit rates. The rise in the bank lending rate increases the cost of borrowing. As households and businesses borrow less, they also spend less which in turn weakens demand. Additionally, as deposit rates go up, households find it more attractive to deposit their savings in the banks, rather than spending it in the shops. As a result, both consumption and investment start slowing. And as aggregate demand starts falling, prices start coming down, assuming that there are no disruptions on the supply side. In other words, monetary tightening operates by weakening demand, thereby slowing down both GDP growth and inflation.
For this reason, a standard way for economists to assess the success of monetary policy is by looking at core inflation. If core (that is, underlying) inflation is close to the target, it suggests that monetary policy is doing its job of controlling demand, notwithstanding any temporary deviations caused by flare ups in food or commodity prices. For instance, in the US, after several quarters of aggressive monetary tightening, headline inflation has cooled down quite a bit. Annual inflation in the US fell to 3.1 per cent in January, compared to 6.4 per cent a year ago. However, core inflation continues to be sticky and has been rising more than expected. Also, wages in the services sector have been persistently high. Both these indicate that demand conditions remain strong, thereby causing the US Fed to delay rate cuts.
Now let’s turn to what’s been happening in India.
Between May 2022 and April 2023, the RBI raised the policy repo rate by 250 basis points. Since then, it has held the repo rate constant at 6.5 per cent. In response, the weighted average lending rate in the banking sector has gone up by less than 200 basis points while the average deposit rate has gone up by more than 200 basis points. Even though the transmission remains incomplete, the resultant decline in demand seems to have started softening prices. This is evident from the decline in core inflation in recent months and from the RBI’s latest forecast, which shows that CPI inflation will come down to 4.5 per cent in 2024-25, much closer to the target. So far, so good.
The story however gets confusing if we look at the RBI’s GDP growth forecast. The economy is expected to grow at 7 per cent in 2024-25 amidst a slowing global economy, implying that domestic demand will be quite strong. This raises a set of puzzling questions: If indeed monetary policy is slowing demand down and cooling off inflation, how can GDP growth continue to be high? Alternatively, if demand will somehow be strong next year, then why would inflation continue to fall?
The recent MPC statements are silent on this. In particular, they do not mention the lagged impact of tight monetary policy on the growth outlook. This seems like an important omission especially since the passthrough is not yet complete and will most likely continue to work through the system over the next few months, thereby further dampening demand.
Given that the legal mandate of the inflation targeting framework is “price stability with an eye on growth”, these puzzles need to be resolved before the RBI can figure out the appropriate stance of monetary policy.
Consider the following: If indeed the economy is expected to perform well in 2024-25, there is no imminent need for a rate cut. We may even see a resurgence of inflation, given that demand conditions are predicted to remain strong. If, however, the underlying demand conditions are weakening, then a rate cut may be needed sooner. After all, the last thing a slowing economy needs is a tight monetary policy. It will be interesting to see how monetary policy responds to this conundrum.
The writer is associate professor of Economics, IGIDR
Between May 2022 and April 2023, the RBI raised the policy repo rate by 250 basis points. Since then, it has held the repo rate constant at 6.5 per cent. (Representational Image) 
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