Reserve Bank’s policy thrust: Monetary tightening to tackle inflation


For the eleventh time in a row, the Reserve Bank of India (RBI) has decided to keep the main policy rate – repo rate – unchanged at 4%. It has also retained its accommodative stance, but indicated it will engage in a gradual and calibrated withdrawal of surplus liquidity to rein in inflation. The central bank has now decided to focus on inflation over growth by sucking out money from the system in a multi-year time-frame.

What is the big picture emerging from the monetary policy review?

In the wake of the rise in crude oil and commodity prices and the impact of the Russian invasion of Ukraine, RBI has slashed the growth forecast to 7.2% for fiscal 2022-23 from 7.8% projected earlier. Although India’s direct trade exposure to the countries at the epicentre of the conflict is limited, the war could potentially impede the economic recovery through elevated commodity prices and global spill-over channels.

Also, financial market volatility induced by monetary policy normalisation in advanced economies, renewed Covid-19 infections in some major countries with augmented supply-side disruptions and protracted shortages of critical inputs such as semiconductors and chips, pose downside risks to the outlook, RBI said.

RBI has also increased the retail inflation projection from 4.5% to 5.7% in 2022-23. The spike in international crude prices since end-February poses substantial upside risk to inflation through both direct and indirect effects. Sharp increases in domestic pump prices could trigger broad-based second-round price pressures. A combination of high international commodity prices and elevated logistic disruptions could aggravate input costs across agriculture, manufacturing, and services sectors. Their pass-through to retail prices warrants continuous monitoring and proactive supply management, the policy panel said.

How has inflation moved of late?

The RBI’s objective is to achieve the medium-term target for consumer price index (CPI) inflation of 4% within a band of ±2%, while supporting growth.

Provisional CPI data for February released by the NSO on March 14 showed that headline CPI inflation (year-on-year) for February 2022 edged up to 6.1% from 6% cent in January. The rise in oil and commodity prices and supply disruptions due to the war have led to a global rise in inflation. Retail inflation, which is considered a trigger for the RBI’s interest rate hikes, rose to 5.59% cent in December 2021 from 4.9% in November, 4.48% in October, and 4.35% in September.

Overall, external developments during the past two months have led to downside risks to the domestic growth outlook and upside risks to inflation projections presented in the February MPC resolution. Inflation is now projected to be higher and growth lower than the assessment in February, RBI Governor Shaktikanta Das said.

On the food price front, global factors such as the restrictions on wheat supplies from Ukraine and Russia via the Black Sea route and the unprecedented high international prices of wheat could have implications for domestic wheat prices. Edible oil price pressures are likely to remain elevated in the near term due to export restrictions by key producers as well as loss of supply from the Black Sea region.

However, a likely record rabi harvest would help to keep domestic prices of cereals and pulses in check.

What policy instruments has the RBI proposed to tackle this situation?

The RBI’s liquidity management is characterised by two-way operations: through variable rate reverse repo (VRRR) auctions of varying maturities to absorb liquidity, and variable rate repo (VRR) auctions to meet transient liquidity shortages and offset mismatches.

In this review, the RBI has introduced the Standing Deposit Facility (SDF) – a new tool for absorbing liquidity – at an interest rate of 3.75%. So while the MPC maintained status quo on the repo rate and kept the stance accommodative, it signaled the normalisation of the liquidity adjustment facility (LAF) corridor by introducing the SDF as the floor rate in place of the fixed rate reverse repo (FRRR), which was kept unchanged at 3.35%.

Analysts said this would enable the central bank to mop up liquidity without providing any collateral. Both the standing facilities viz., the MSF and SDF, will be available on all days of the week, throughout the year.

The FRRR rate, retained at 3.35%, will remain part of the RBI’s toolkit, and its operation will be at the discretion of the RBI for purposes specified from time to time. The FRRR along with the SDF will impart flexibility to the RBI’s liquidity management framework, the RBI said. The extraordinary liquidity measures undertaken in the wake of the pandemic, combined with the liquidity injected through various other operations of the RBI, have left a liquidity overhang of the order of Rs 8.5 lakh crore in the system, according to Das.

What is the trade-off in the RBI’s policy with regard to growth?

The RBI has now decided to focus on inflation over growth as inflation remains above the RBI’s upper band of 6%. The policy panel decided to remain accommodative while focusing on withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth.

While the RBI has been focusing on growth with its accommodative policy in the last three years, several analysts recently said it is behind the curve in tackling inflation and liquidity management. “In the sequence of priorities, we have now put inflation before growth. Time is appropriate…,” Das said.

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Is a long-term tightening of money supply indicated?

The RBI has said it will engage in a calibrated withdrawal of the accommodative stance over a multi-year time frame in a non-disruptive manner beginning this year. The objective is to restore the size of the liquidity surplus in the system to a level consistent with the prevailing stance of monetary policy. “While doing so, I would like to reiterate our commitment to ensure the availability of adequate liquidity to meet the productive requirements of the economy,” Das said.

That said, the gradual tightening of money supply is expected to push up interest rates. The liquidity measures undertaken in the wake of the pandemic, combined with liquidity injected through various other operations of the RBI, have left a liquidity overhang of the order of Rs 8.5 lakh crore in the system.

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Divyansh Singh

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