Much to the chagrin of an erudite policy maker a young economist once said to be a successful macroeconomist one needs to know only three phrases; inflationary expectations, output gap and supply shocks, these three affect the cost of living. In what order and after how much time (i.e. lags) one is not sure of. Iconoclasts are never appreciated, that’s a different story.

For an emerging economy like India which is coming out of pandemic related disruptions, 2022-23 is unlikely to be an easy year. The unusual increase in global fuel, food and commodity prices on account of the Ukraine war along with supply chain breakdown due to extended lockdown in China have had a rub off effect on all emerging economies. The issue has got further buttressed by the pursuit of contractionary monetary policy by advanced economies. This has led to an outflow of capital, currency depreciation, higher debt servicing cost, etc., in emerging countries.

Given this scenario, RBI decided to go for a mid-cycle rate increase by 40 basis points and a CRR increase of 0.5 percent, after all a 7.79% inflation rate in April was too disturbing to be ignored, some signalling was required for both economic and political reasons. Government has also been proactive in bringing down excise duty on petrol and diesel and import duty on edible oil. However, the fiscal deficit target will always remain a binding constraint, unless GST collections go up further to allow further reductions.

Unfortunately it has been often argued that the RBI was behind the curve in raising rates and changing the monetary stance. Uncertainty in a situation of war with its concomitant negative externalities can upset all projections about inflation and growth. Policy makers cannot be held responsible for this. There are other macroeconomic issues too; liquidity growth has not been very high in recent years, it has been largely contained in high single digit during last one year, what rate increase will affect is inflationary expectation that too with a lag. Notwithstanding some empirical studies, policy makers are not very clear on the cumulative magnitude of rate increase and CRR increase that can anchor inflationary expectations. The transmission mechanism of monetary policy and its lagged impact under conditions of uncertainty always raises more questions than what it answers. It will be interesting to see how long it takes to bring down inflation to four plus/minus two target. One may recollect that notwithstanding several interest rate increases, CPI inflation for industrial workers during 2009-10 to 2013-14 used to be 10.3% per annum on an average, WPI inflation used to be 7.1%. Currently, we do not have a positive output gap, demand is certainly not surging. We are waiting for private consumption and investment to pick up. It has been estimated that GDP in 2022-23 can touch 7 percent plus after -6.6% and 8.9% in 2020-21 and 2021-22 respectively. Due to the covid impact the average GDP growth in three years from 2020-21 to 2022-23 will be relatively modest, somewhat lower than the long term trend rate.

Given this scenario, in which economic revival is almost on the anvil, is there a need to aggressively increase rates and curtail liquidity? Is it not going to create unnecessary hurdles for MSMEs, organised sector and infrastructure projects? Couple of month's relatively high inflation spurred by higher price of fuel, metals and certain food items due to supply side shocks should not force one to give up on growth with macroeconomic stability objective. Whichever estimate one takes be it World Bank or IMF there is little doubt that poverty particularly extreme poverty has declined in India, the key trigger for this is higher economic growth. When inflation is supply shocks driven which are emanating from war and other global developments, does it make much sense to go for aggressive monetary measures on a cumulative basis? RBI's basic focus is on consumer price index inflation. It's own research tends to indicate that, "Hardening of global commodity prices has a relatively moderate impaction CPI inflation relative to WPI inflation, but the impact on CPI core is more persistent." One percent change in global commodity prices can lead to 0.02 percent increase in overall CPI inflation.

To protect us from global price movements one has to keep exports and currency competitive possibly in line with REER (Real Effective Exchange Rate). Price elastic imports will be automatically taken care of. For inelastic imports one may have to use a fraction of foreign exchange reserves, which is currently equivalent to eleven months of imports.

Siddhartha Roy is the former Economic Advisor of the Tata Group. Currently he is the CEO of SR Associates an Economic Advisory and Strategic Consultancy enterprise.

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