Context

Recently, the RBI has been at the receiving end for mission the inflation target.

Understanding the RBI’s rationale

• Supply side shock: Inflation has been largely the result of supply side shocks from vegetable prices, caused by crop damages due to unseasonal rains (tomato, onion and potato) in late 2019 and widespread supply-side disruptions after the outbreak of the pandemic.
• A narrow-minded focus on inflation caused by supply shocks would have constrained the MPC from supporting growth amidst the unprecedented loss of life and livelihood.
• Focusing on recovery: Therefore, it was necessary to provide a lifeline to the economy at that juncture by focusing on the recovery.
• Moreover, the wide tolerance band of 200bps +/- in the inflation targeting framework was specifically designed to accommodate such supply shocks, which provided the flexibility in the flexible targeting (FIT) framework.
• Taking into account objective of growth: In contrast to a pure inflation targeting framework (inflation nutters), the amended mandate of the RBI under FIT reads as “price stability, taking into account the objective of growth”.
• Therefore, the MPC was justified in looking through the higher inflation print during the pandemic while trying to resurrect growth.

No contradiction between Governor’s statement and MPC resolution

• Recently, the MPC highlighted inflation concerns and voted to raise the policy repo rate.
• The governor’s statement of the same day noted that the RBI will ensure an orderly completion of the government’s borrowing programme.
• Contradictory objectives: It is said that the above two actions created confusion as lowering inflation and lowering government bond yields are contradictory objectives.
• This justification is redundant as an orderly completion of the borrowing programme does not imply lowering yields.
• It basically ensures that the borrowing programme is completed seamlessly at low costs (ensured through auctions).
• Moreover, from a theoretical perspective, this is not inconsistent because controlling inflation and lowering inflation expectations bodes well for the term premia of bond yields — which moderate once expectations are anchored.
• Therefore, if inflation is reined in, the government stands to gain in terms of lower interest costs.
• Was width of corridor lost during pandemic? It is argued that  the MPC kept repo rates unchanged while the RBI changed the reverse repo rate during the pandemic, meaning that the fixed width of the corridor was lost and the MPC lost its role in setting interest rates and so, its credibility.
• This argument does not stand scrutiny.
• During the pandemic, the policy repo rate was cumulatively reduced by an unprecedented 115 bps and the interest rate on the overnight fixed-rate reverse repo was reduced cumulatively by 155 bps.
• Assymetric corridor justified in crises: This measure was not incongruous with contemporary wisdom as an asymmetric corridor has been justified, particularly during crisis times (Goodhart, 2010).
• Given that elevated inflation concerns precluded the possibility of any further repo rate cuts (cumulatively reduced by 250 basis points since February 2019), financial conditions were eased substantially by reducing the reverse repo rate, which lowered the floor rate of interest in the economy.
• Since the mandate of the MPC is to control inflation for which the policy instrument is the repo rate, the RBI had used the LAF through changes in the reverse repo rate to alter liquidity conditions.

Trade offs involved in inflation targeting for emerging economies

• Inflation-targeting countries, because of their sole focus on inflation, experience lower inflation volatility but higher output volatility.
• Higher output volatility entails a higher sacrifice ratio — the proportion of output foregone for lowering inflation.
• For an emerging economy, the costs of higher output foregone against the benefits of lower inflation must always be balanced as potential output keeps on changing given the shift of the production function.
• Developed countries, on the other hand, operate near full employment — therefore, sacrifice ratios are lower.
• As a result, smoothening inflation volatility is relatively costless for them.

Conclusion

The RBI has innovated admirably under its current stewards during the pandemic, keeping in mind the task of reinvigorating the economy. Despite the existing targeting framework, it did not get fixated on a one-point agenda, daring to look beyond the inflation print.

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Back2Basics: Liquidity corridor

• The Corridor in monetary policy of the RBI refers to the area between the reverse repo rate and the MSF rate.
• Reverse repo rate will be the lowest of the policy rates whereas Marginal Standing Facility is something like an upper ceiling with a higher rate than the repo rate.
• The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.

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