‘RBI in wait-and-watch mode on inflation risks,’ says deputy governor Poonam Gupta

Monetary policymakers often face their biggest challenges when unstable geopolitics conspires with economic hurdles — an energy-sapping war, threats to global commerce, and nerve-jangling currency movements that threaten to disrupt budgets and fund flows.

How does the Reserve Bank of India (RBI) plan to deal with them? Deputy governor Poonam Gupta explains the central bank’s approach, in an interview with Sangita Mehta & MC Govardhana Rangan. Edited excerpts.

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In the minutes of the MPC meeting, you come across as the most optimistic on growth. Is the continuation of the conflict changing it?

The reason for my perceived optimism is because over the past few years, growth outcomes have surprised us on the upside. During the current fiscal year, which has just started, negative shocks have been frontloaded. It is quite possible that positive surprises will follow during the year.

Among the obvious ones are the culmination of a conducive trade deal with the US; the ongoing West Asia conflict being resolved; the favourable impact of the recent trade and investment deals to start filtering in; resulting in an improvement in sentiment. Second, we do not see any capacity constraints in the economy.

Instead, we see spare capacity, which will help meet any increase in the global and domestic demand. Finally, the effects of the ongoing reforms processes have started to cumulate and yield results on multiple fronts: higher growth, sustained macroeconomic and financial stability, and increased productivity.What was RBI’s assumption on the likely duration of the war and the damage the conflict could cause to the Indian economy?

Our base-case assumption is that the conflict would be resolved within a few months, after which supply chains would be restored in subsequent months, and supply and demand should normalise. Accordingly, if you look at our baseline quarterly path for growth, maximum adverse impact on growth is projected in the first half of the year. We see recovery in growth in the second half, the extent of which, however, would depend upon how fast supply chains are restored and where energy prices settle after the end of the conflict.

Your inflation projection for next year is within the band but above the target. Given the external macro situation, are you willing to look through inflation for growth?

In principle—and this is what most countries do—when inflation is temporarily high or above the target due to supply-side factors beyond their control, the first-best response is to look through it. You do that until there is a risk that inflation becomes entrenched and triggers second-round effects. As of now, there is no evidence of secondround effects on inflation expectations becoming unanchored; therefore, we have decided to watch and wait.

The prevailing tolerance band around the target helps accommodate supply shocks and tolerate inflation deviations from the target in the short run to avoid policy induced volatility through frequent changes in interest rates. Yet, we are keeping a close vigil on the evolving developments.

How do you think about second-order impacts, and central banks looking through first-order impacts of the current energy price shock?

The exact impact would depend on the duration of the West Asia conflict and how quickly normalcy returns to energy markets post conflict. The first-order impacts would depend on the magnitude and duration of the cumulative energy price shock, as well as on how much of it would be absorbed by the respective governments vis-a-vis how much would be passed on to consumers. The secondorder impact would depend on whether higher energy price increases become entrenched so they start getting reflected in the prices of all other goods and services and turn into a wage-price spiral. In India, so far, only a part of the higher energy prices has been passed on and the rest has been absorbed by the government. So even the direct firstorder pass-through has been limited at this stage, and to that extent, the second-order impacts are further low.

Historically, it is the spillover effects of the price rise that economists worry about…..

On one particular channel of secondorder impacts, the wage-price spiral, India is less susceptible than many other countries, which have a more formal and tighter labour markets; a history of high inflation; where wages are indexed to inflation; or where wage contracts are collectively bargained. In India, wage adjustments happen with a much longer lag. While labour markets are becoming more formal, and some inflation-linked wage bargaining is starting to appear, but for the most part it has remained limited. So, my sense is that the risk of a temporary shock turning into entrenched inflation through these channels is limited as yet. That said, if more unanticipated shocks occur or the conflict prolongs, then the possibility of secondround effects cannot be ruled out.

One of the biggest macro challenges for policymakers for a long time has been the impossibility trinity. Which of the three takes priority?

As per a theoretical concept of impossible trinity, emerging markets’ central banks ought to choose any two of the following: open capital account, fixed exchange rates, and an independent monetary policy (which is primarily guided by domestic considerations rather than external developments). Over time, emerging market economies have liberalized their capital account, and have moved away from pegged exchange rates to managed floats. In addition, central banks, especially those operating under an inflation-targeting framework, have been able to conduct monetary policy primarily based on domestic considerations.

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This is not to say that external factors do not matter at all for the core central banking functions—they do matter to the extent that they affect the domestic growth–inflation combination or financial stability. As for the exchange rate, central banks use other tools – such as occasional intervention in forex markets to curb excessive volatility or abrupt movements, and central bank communication. In practice, while managing impossible trinity, the endeavour is to avoid corner solutions and to use the tools at its disposal as necessary.

It has been a decade of inflation targeting in India. Did it help or restrict policy choices?

Inflation targeting has been around for more than three decades. India was one of the later adopters of the framework when it adopted it in 2016. No country has ever left it. Though many of them have modified it. Emerging markets have reduced the inflation targets they initially adopted and narrowed the band. Over the last 10 years, the level and volatility of inflation have declined. Inflation expectations have become more anchored. Monetary policy has become more transparent and draws greater credibility. I would also say that there is better co-ordination between monetary and fiscal policies —this coordination has helped optimise the benefits of the inflation targeting framework.

The framework has been challenged by external shocks and some argue it is rigid..

In the last five years, the framework has been tested by repeated external shocks—COVID, the Ukraine-Russia war, high inflation internationally, and now the ongoing conflict in West Asia. I (in my research paper) found that inflation targeting central banks were able to respond to COVID with more agility. They could ease monetary policy more aggressively because they had built credibility over the years, which they could leverage. This is exactly what India has been able to do as well over the past decade.

In addition, the tolerance band of plus and minus two percent around a target level of 4 percent, has also provided the flexibility to respond to external shocks, while maintaining the focus on the medium-term objective of price stability. Overall, the framework has worked well internationally, and the Indian experience has been similar.

Inflation targeting worked well for 30–40 years and created room to respond to crises. But after large monetary expansion, how effective it could be in future?

My sense is that the framework will continue to serve most economies well. This is despite the fact that inflation in advanced economies has remained above target during the past few years. But the inflation expectations among households and firms have remained largely anchored. During the recent shocks, central banks have been seen to be more patient and tolerant about inflation rates exceeding their respective targets, including the US Fed, ECB, Bank of England, and Bank of Japan.

Such a stance has also been backed by clear communication from central banks—showing commitment to the framework—which has helped keep the expectations anchored. Iexpect that most countries will keep the frameworks as they are and will continue to try to meet the targeted level of inflation.

If the monsoon turns out to be subnormal, as projected by the IMD, how much could this impact GDP growth and inflation?

We assessed the probability of an El Nino. These indicated that while there was a relatively high probability of an El Nino this year, the forecast rainfall shortfall was perceived to be small, around 7% to 9%. Taking available information into account, we assessed how resilient agriculture has been to a rainfall deficiency of this order.

In the past, when an El Nino led to a similar shortfall—around 8%—it did not result in a decline in agricultural output. This is because the agriculture sector has become more resilient to shocks due to better irrigation, better water storage, enhanced ground water harvesting, better inputs, climate-resilient varieties and more mechanisation.

Our sense is that this event is unlikely to have a significant impact on agriculture. Past data suggests that if rainfall deficiency is much greater- —say, exceeding 15%—then its impact on agriculture becomes apparent. A rainfall deficiency of up to 10% has not, in the recent years, had a major impact on agriculture.