Opinion RBI’s challenge: Did the central bank fail to anticipate the economic slowdown?

Over the next few days, the RBI’s monetary policy committee will hold its last scheduled meeting for this calendar year. So far, the central bank’s “resilient” growth outlook provided the committee the space to keep the policy rate unchanged and focus on “attaining a durable alignment of inflation with the target”. However, since the last committee meeting in October, the macroeconomic scenario has changed dramatically — inflation has edged upwards, while growth has slowed down. In this changed environment, questions are being asked, including by the government, about whether the RBI has kept interest rates too high for too long, not anticipating the economic slowdown.

As reported in this paper, the government has raised questions over the stance of monetary policy, calling into question the central bank’s assessment of the underlying growth momentum and price dynamics in the country. On growth, it viewed the RBI’s exuberance — the central bank had raised its growth forecast to 7.2 per cent for the year in June — as out of sync with other signals. Thereafter, even when economic indicators subsequently pointed towards a slowing growth momentum, the central bank continued to exude confidence about the economy’s growth prospects, retaining its growth forecast in the October MPC meeting. Its assessment was also at odds with some segments of India Inc who have spoken frankly about the pain points in the economy. The economy grew at 5.4 per cent in the second quarter, compared to the RBI’s assessment of 7 per cent in the October MPC meeting. There is also disagreement with the central bank’s assessment of the underlying price pressures in the economy. The RBI is worried about the second round effects of high food inflation spilling over to core inflation. But as per government officials, there are no second round effects. Excluding gold and silver, core inflation is stable. Moreover, the surge in headline inflation over the past two months has been largely due to food inflation, which in turn is driven by vegetables. Analysts expect vegetable prices to show some moderation in the coming data.

Advertisement

RBI’s inflation targeting framework of 4 plus/minus 2 per cent has a degree of flexibility that gives the committee the space to look through such transient supply side shocks. Monetary policy works with long lags. With the RBI’s forecasts now showing inflation at 4.2 per cent in the fourth quarter of this financial year, and 4.3 per cent in the first quarter of next year, real interest rates remain at levels that former MPC members have characterised as excessively restrictive. The question now, after the recent GDP data, is whether the MPC will continue to attach primacy to inflation, or will growth considerations also dominate its thinking, or will the currency now also be a factor. The RBI has multiple policy tools at its disposal. It will need to draw on them as it navigates the rapidly changing environment.