High inflation threat forces RBI to signal change in priorities

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A prolonged output gap in the economy is still waiting to be bridged, but the Reserve Bank of India had no option but to shift its focus to its principal mandate of inflation targetting after giving growth apparent priority for over two years. Given that geopolitical developments have amplified the threat of imported inflation, the RBI would have come under the glare of criticism, had it not signalled a change in priority at this juncture.

Another factor that weighed on the mind of the Monetary Policy Committee while articulating the shift is the persistently high ‘core inflation’ which is more amenable to monetary policy action. Though food and beverages dominate the consumer price index with an almost 46% weight, core inflation (non-food, non-manufactured products) too has remained sticky, having exceeded the 5%-mark for 21 months through February.

The RBI on Friday trimmed its FY23 forecast for the country’s economic growth to 7.2% from 7.8% announced in February, citing the impact of elevated crude oil and other commodity prices in the wake of the Russia-Ukraine conflict. It also referred to tightening of global financial conditions, persistent supply-side disruptions and subdued external demand.

At the same time, the central bank revised up sharply its retail inflation forecast for FY23 to 5.7% from 4.5% seen in February. It expected the persistence of elevated input cost-push pressures for a longer period than assumed earlier, given the broad-based rise in international commodity prices. Their pass-through to retail prices, though limited until now due to the continuing slackness in the economy, needs to be monitored carefully, it stressed.

A day earlier, the finance ministry had said that should the current elevated level of international crude price persist for a long time, it could come in the way of India achieving a real economic growth rate of 8%-plus in FY23 and pose upside risks to inflation.

The latest Economic Survey, presented before the Ukraine crisis, had pegged real growth for FY23 at 8-8.5%. More recently, some analysts have trimmed their FY23 growth projections to 7-8.5%. Retail inflation, meanwhile, scaled an eight-month peak of 6.07% in February, having hit the upper band of the RBI’s medium-term target of 2-6% for a second straight month. This is expected to have risen further in March due to the hike in domestic fuel prices.

The government is exploring all viable options, including import diversification, to procure crude oil at an affordable price, the department of economic affairs said in its report for March.

The revised inflation forecast for FY23, which reflects the central bank’s assessment of a steady decline, assumes normal monsoon and average crude oil price of $100 per barrel. It has projected 6.3% inflation for the first quarter, followed by 5.8% for the second quarter, 5.4% and 5.1% for the third and fourth quarters, respectively.

Crude prices scaled 14-year peak of $140 per barrel in early March and, despite some corrections, they still remain volatile at elevated levels.Moreover, a surge in international prices of key food items, including edible oils, and animal and poultry feed due to a supply crunch “impart high uncertainty to the food price outlook, warranting continuous monitoring”, the central bank said, calling for pro-active supply management to contain inflation.

As for economic growth, the central bank has now projected real expansion for Q1 at 16.2% (aided by a favourable base), Q2 at 6.2%; Q3 at 4.1%; and Q4 at 4%.Madan Sabnavis, chief economist at Bank of Baroda, said: “There is a clear hint that the accommodative stance, though retained, will change as there will be a gradual withdrawal of liquidity keeping in mind the trends in inflation.”

Aditi Nayar, chief economist at Icra, said although the governor hinted at using various tools to manage the government’s borrowing programme, “comments on the yield curve being a public good were missing in his morning speech, suggesting that (G-Sec) yields will be allowed to move up gradually”.

Indranil Pan, chief economist at Yes Bank, said governor Das indicated that “the order of preference for the RBI now is inflation, growth and financial stability, rather than the post Covid-19 preference of preserving and supporting growth momentum”. The process of neutralising monetary policy had already started with withdrawal of ultra-comfortable liquidity.

Prasenjit Basu, chief economist at ICICI Securities, said two reasons justify the MPC’s latest policy stance. First, inflation is high partly because of (external) supply shocks, so reducing aggregate demand through monetary tightening will not address the issue. Second, there is a considerable output gap, with the economy having contracted 6.6% in FY21, and estimated to have grown 8.9% in FY22 (far from closing the gap, in an economy with potential growth of 7% annually).