RBI must pause rate cuts to anchor inflation expectations

Clear communication is required that the inflation spike is temporary and the RBI will remain accommodative as long as it takes for growth to pick up.

By Ashima Goyal

The divergence between CPI and WPI inflation continues with the former still staying above the Reserve Bank of India’s target band. That CPI food inflation is higher than WPI food inflation, suggesting it is temporary due to the disruption of retail supply chains.

Heavy rains have also contributed to the rising food prices. The marginal increase in minimum support prices and flat rural wages imply that there will be no second-round effects, and headline is expected to revert to a core that will be low because of soft demand.

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It is important to continue anchoring inflation expectations. So, a pause is called for at present. But clear communication is required that the inflation spike is temporary and the RBI will remain accommodative as long as it takes for growth to pick up — which is likely to take longer since the coronavirus has turned out to be persistent. The US Fed has given such an assurance for 3 years. Although details may be difficult to give now because of extreme uncertainty, industry and markets will respond now.

Since fiscal borrowing and spending will have to step up, a similar assurance of support for government spending should be given. Special Covid-19 bonds can be announced to make clear that such support is limited to the current special situation. Other measures should continue to be taken to reduce interest rate spreads. For example, RBI’s targeted long-term repo operations could be made conditional on reducing loan rates, and tiered reverse repo support for banks conditional on passing through in deposit rates. The ECB has tried this dual interest rate policy.

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Excess capital flows due to quantitative easing when there is a current account surplus, add to liquidity, expand the RBI’s balance sheet and make it difficult for it to support government borrowing. In the literature it is acknowledged that emerging markets need some kind of market-based capital flow management and macro-prudential measures as well as more exchange rate flexibility to manage this quadrilemma.

(Dr Ashima Goyal is Professor at Indira Gandhi Institute of Development Research, Mumbai and member of Prime Minister’s Economic Advisory Council. This article is a reproduction of her views presented at the shadow monetary policy committee of EGROW Foundation, a Noida-based think tank.)

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