RBI’s Hamletian Dilemma

Business Standard     28th July 2020     Save    

Context: The relationship between monetary policy and inflation is not reliable in a crisis, creating a classical problem for the central bank.

Role of Monetary Policy Framework 2015:

  • Flexible Inflation Targeting (FIT): was formally adopted in India
  • The Central Government, in consultation with the RBI, notified the inflation target of 4.0% - with 6.0% and 2.0% as the upper and lower tolerance levels.
    • Inflation target applicable from August 5, 2016, to March 31, 2021.
    • In case of failure to sustain the targets, RBI would send a report to the central government stating the reasons for its failure and propose remedial measures to be taken.

Issues with the FIT regime in recent times:

  • Inflation consistently higher than 6% mark: since December 2019 with the exception of March 2020.
  • Given the limited lockdown and its re-imposition – supply shocks may continue until the COVID situation improve.
  • Continuing deceleration even before the pandemic:
  • Indian growth had been decelerating over the last eight quarters, and the January–March 2020 quarter saw a low growth rate of 3.1%.
  • Liquidity conditions have been kept in the surplus mode since June 2019.
  • Negative apprehension of the pandemic: Lowest growth in 40 years
  • The International Monetary Fund in its June 25 projections has placed Indian growth for 2020-21 at (-) 4.5%
  • Provision of sizeable monetary stimulus: to rejuvenate the depressed economy.
  • RBI since February aggregated to about Rs 9.57 trillion (equivalent to about 4.7% of 2019-20 nominal GDP).

Way Forward: 

  • RBI should stick to FIT regime: Even though high inflation can pose a dilemma of whether to prolong stimulus or pause rate cut cycle, RBI should take appropriate action as the future unfolds.
  • Place monetary policy decisions under an escape clause: similar to the Fiscal Responsibility and Budget Management Act, that allows the government to borrow money in exceptional circumstances.