#9: RBI's inflation dilemma.

The how and why of monetary policy.

Every two months, the Monetary Policy Committee (MPC) of the RBI releases its monetary policy statement, basically, a document outlining the interest rates for lending and borrowing as prescribed by the RBI.

These rates have a direct bearing on the level of economic activity and inflation in the economy - which are among the most important factors of the performance of any business in that economy. No wonder, this monetary policy statement is keenly watched by equity investors.

The key dilemma faced by the RBI in determining its monetary policy stance (direction) is inflation vs. growth. If it must boost growth, interest rates will be lowered (but that results in higher inflation). If the RBI targets controlling inflation, interest rates will be increased (but that puts off fast growth).

One might say that the choice is easy given the post-COVID economic scenario. The economy demands firing from all cylinders to get back on the recovery path. And RBI agrees with that. It indeed has adopted an ‘accommodative stance’, which basically means that it will focus on keeping the interest rates low to help the recovery.

However, there is a law in place that asks RBI to keep the retail inflation rate in the country at 4%. It also allows a margin of ±2%, which means that the inflation rate may fall up to 2% or rise up to 6%. The intent of providing this margin of 2% is designed to allow for forecast errors, implementation shortfalls, and measurement issues. The target remains 4%.

This means that if the retail inflation crosses 6% or falls below 2%, controlling the inflation must become a top priority for the RBI. The CPI inflation stood at 6.3% in June 2021.

Yet, given the unprecedented crisis to the economy, the RBI chose to maintain its accommodative stance. But, that was not the only reason.

When inflation goes too high, it is often worthwhile to look at the break up of this figure to find out what is causing the major shifts. For example, when inflation stands at 6.3%, it does not mean that all goods/services in the economy have become expensive by 6.3%. There might be some things that have gone up by 11%, others only by 1%.

Looking into this data for the month of June, it shows that there have been two major areas of high price rises - food and fuel.

Food and fuel prices are notorious for being highly volatile in nature. The prices of food and fuel react fast when any economic package is given, or any variable moves sharply. Therefore, when the headline inflation is high only as a result of food and fuel prices, it tends to be only watched (and no action is usually taken) in the short term.

Knowing this, the RBI has preferred to defer its concerns around inflation. And it has been doing so since COVID arrived in India. It seems that it cannot be done forever. In fact, in the 5-member MPC, there was a dissenting voice against the accommodative stance. He was voted out 4 to 1, but it does reflect that RBI will find it difficult to ignore the high inflation rates going forward.

Investors must remain cautious as any increase in interest rates by the RBI can cause a reaction from the markets.

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Surbhi Singhal is a Chartered Accountant and a Company Secretary; and the founder of Advance Thinktank. The company specializes in preparing custom research reports regarding investment opportunities in India, tailored to the client's needs.