Growth Inflation Trade-Off: RBI's Fuzzy Dichotomy

On Feb. 8, 2023, the Reserve Bank of India hiked the repo rate by 0.25% to 6.5%. Consumer price inflation for January came in at 6.52%, up from 5.72% in December 2022. In its monetary policy statement, the RBI said the decision was in "consonance with the objective of achieving the medium-term target for CPI inflation of 4% within a band of +/-2 while supporting growth."

On Aug. 8, 2024, the RBI decided to "keep the policy repo rate under the liquidity adjustment facility unchanged at 6.50%." Consumer price inflation in July came in at 3.54%—down from 5.08% in June. The MPC statement continued with the convoluted semantic construct of "withdrawal of accommodation to ensure that inflation progressively aligns to the target while supporting growth."

It has been 18 months since India's benchmark repo rate has stayed at 6.50%. In this period, inflation has come down from 6.52% to 3.54%. Indeed, in the August assessment, the RBI points out that "Core (CPI, excluding food and fuel) inflation at 3.1% in May–June touched a new low in the current CPI series, with core services inflation also at its lowest in the series." The MPC statement also projected CPI inflation for 2024–25 at 4.5%.

Yet, despite its assessment of the balance of risks, the RBI chose to continue with a higher rate. The fact is, central banks have cut rates and taken contextual calls to support growth—in Switzerland, Sweden, Canada and Europe. And it is not that the MPC's decisions have been without dissent—MPC members Ashima Goyal and Jayanth Varma have dissented both on the rate and the stance. Goyal underlined that "the real rate affects the real sector" and the imperative for India "to create more productive jobs in order to utilise the demographic dividend as well as to prevent possible political instability." Varma repeated his "concerns about the unacceptable growth sacrifice induced by a monetary policy that is excessively restrictive."

The persistence of the RBI with a higher rate regime is a stance in search of a rationale. The phantom in the room is the fear of food inflation, even though monetary policy has struggled to slay it. Food price inflation has been sticky at around 7% and more despite higher rates and the stance of withdrawal of accommodation. What also merits attention is the migration of concern. In January, the RBI, in its monthly bulletin, underlined the stickiness of food inflation and argued "food inflation is generally considered to be outside its (monetary policy) ambit." In August, the monthly bulletin flagged food price inflation again and argued this time that "monetary policy must be disinflationary to quell these price pressures in order to achieve its mandate of price stability and thereby retain credibility."

Theory defines price stability as the condition where changes in the general price level do not alter the decisions of households and businesses. Call it the Goldilocks state or the state of equanimity. Effectively, this is orchestrated by raising the cost of money to contain the quantity of capital flowing into the economy or cutting interest rates to enhance the liquidity needed for fuelling output. This trade-off between enabling growth and containing inflation calls for calibrated policy.

Any overshoot on either side carries the consequence of impacting the real economy as they alter economic behaviour or households and businesses and inspire expectations. Indeed, central banks have been charged with causing recessions—in the United States in 2001 after the US Fed hiked rates from 4.75% to 6.5%, in Europe in 2011 when the ECB ramped up rates—and the slowdown in India in 2018. Milton Friedman, who authored the construct of "long and variable lags," described the situation with a memorable coinage of the 'fool in the shower' who is stranded between scalding and freezing water as he tinkers with the temperature.

The debate is not about whether the RBI is right or wrong in its stance but whether it fulfils what is required for the economy. The GDP data for the first quarter is the lowest in five quarters at 6.7%—the momentum the RBI was content with has slid. The political economy question is whether higher interest rates serve the interests of the real economy. Context is critical for policy. The GDP data for 2023–24 underlines the gap between the 8.2% print and the sub-4% level of private final consumption.

Consumption is the single largest component of the GDP and fuels capacity expansion and job creation. It is estimated that India's demography—with a median age of 29—demands over 8% growth. The wealth effect triggered by record high levels of stock indices may prop consumption, but it is governed by the statute of limitations. Already data on corporate earnings show a slide and this will clearly guide the levels of stock indices. The earnings reflect the stress in rate-sensitive sectors—construction, housing, travel, services—which are critical for job creation.

On the face of it, the RBI's stance suggests it is willing to sacrifice growth for targeting inflation. The question is, can India afford to sacrifice growth? If it is so, what is an acceptable sacrifice? In the past, the RBI has frequently taken refuge under the phraseology of data dependence. Analysis of the data as it stands in August suggests that the gap between the policy rate and current inflation is at 2%. Is 2% the accepted neutral rate for an emerging economy? Is the higher cost of capital conducive to India maintaining and enhancing competitiveness to expand its global footprint? Is the RBI suggesting that an economy dependent on investment-led growth and sensitive to the cost of capital can withstand the higher rate regime?

Globally, central banks are shifting their stance to a cut in rates—at the recent Jackson Hole symposium, Powell signalled, "The time has come for policy to adjust." Bank of England Governor Andrew Bailey emphasised "careful" reductions in borrowing costs going forward and officials at the ECB too have indicated an accommodative regime.

The stage is set for the RBI to exit the fuzzy dichotomy defining the trade-off between growth and inflation targeting. In May 2022, the RBI hiked rates by 40 basis points in the face of a rise in inflation in an unscheduled meeting. Perhaps it needs to borrow a page from its history and move to align interest rates to the needs of the real economy.

Shankkar Aiyar, political-economy analyst, is the author of ‘Accidental India - A History of the Nation’s Passage through Crisis and Change , ‘Aadhaar: A Biometric History of India’s 12-Digit Revolution’ and The Gated Republic: India’s Public Policy Failures and Private Solutions. Twitter: @ShankkarAiyar

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