Balancing inflation and growth – Is there a magic wand?

22 Nov 2024 , 12:36 PM

BALANCING THE TWIN OBJECTIVES OF GROWTH AND PRICE STABILITY

Speaking at the high-level policy conference to commemorate the 90th anniversary of the RBI, governor Shaktikanta Das spoke at length about how the RBI time and again is called upon to manage this tightrope walk. Like most central banks in the world, the RBI also has dual objectives. It has to ensure that price stability is maintained in the economy and inflation is now allowed to run riot. High inflation has to be controlled ruthlessly, but this has to be done without forcing the economy into a hard landing. Central banks like the Federal Reserve of the US claim that GDP growth is not the outlook of the central bank. The Fed focuses primarily on price stability and then on full employment. However, full employment is nothing but a proxy for economic growth.

Ironically, inflation and growth often come into conflict with one another. A sustained period of rapid growth results in higher purchasing power and hence higher inflation. There is a problem with higher inflation since even when the nominal growth stays the same, the real growth comes done due to higher inflation. Also, inflation is known to hit the vulnerable sections a lot harder, which is why most central banks are very touchy about inflation going out of control. In the past, the RBI has been called upon to manage one of these thing sat different points of time. In 2008, after the global financial crisis, and in 2020 after the pandemic, the RBI was required to loosen monetary policy and unleash growth. That is what the RBI did. However, by late 2021, inflation was running into double digits globally and by early 2022, the RBI had to change its tack to managing inflation. How does the RBI mange this dual mandate? It would be instructive to understand the FIT framework in this context.

FLEXIBLE INFLATION TARGETING (FIT FRAMEWORK)

One of the ways in which the RBI maintains a balance between growth and price stability is by deploying the flexible inflation targeting (FIT) framework. This has been the practice for over 8 years now, and has worked to perfection. It allows the RBI to maintain balance between price stability and growth within the space provided by the flexible inflation targeting (FIT) framework. For example, the inflation target for the RBI has been set at 4%. However, achieving an absolute number is easier said than done. Hence, the FIT stipulates that the RBI maintain the consumer inflation between a range of 2% on the downside and 6% on the upside; trending towards an average of 4%. This kind of a FIT approach worked well for the RBI during the post-COVID scenario when the RBI had to move its policy focus from aggressive growth inducement to aggressive inflation control in a span of just 2 years.

The FIT framework has given the RBI the flexibility to play with policy options while still respecting the inflation range stipulated by the FIT framework. For instance, the post COVID phase was about boosting growth. Two round of economic activity stagnation was too much to handle. Hence low interest rates and easy money were the answers. Then by late 2021 and early 2022, the supply chain bottlenecks were creating runaway inflation. Demand was surging due to helicopter money, but supply could not keep pace. Later around mid-2023 when growth concerns again started showing up, the RBI was the first among global central banks to pause on rate hikes. In between, the RBI had to contend with two years of bad harvest resulting in runaway food inflation. All these diverse test cases could only be handled; thanks to the FIT framework.

SUPPORTIVE FISCAL POLICIES ARE ESSENTIAL TOO

The RBI governor, in his speech, was quick to point out that much of the RBI success in managing the crisis of growth in 2020 and later the inflation crisis in 2022 was due to a synchronized approach between monetary and fiscal policy. Monetary policy, by itself, can only achieve so much. It needs to the support of fiscal policy measures to actually be effective. Consider these instances.

• In 2020, when the RBI started to loosen the liquidity strings, the government extended full fiscal support. It allowed the fiscal deficit to temporarily go beyond 9% with a clear understanding that fiscal deficit would unwind when the situation normalized.
• The need of the hour in 2021 was economic activity. That is when the government stepped in and decided to give a big boost to capex spending. By growing its capex allocation by 30% each year, it triggered a sustained economic growth phase.
• By 2023, the tide had turned and inflation was starting to reverse, leading the RBI to pause on rate hikes. However, that was also supported by the government setting aggressive targets to bring back fiscal deficit to 4.5%. That synchronization helped.

So, it was not just the monetary policy and the RBI; but even a very complementary fiscal policy made the job a lot easier for the RBI.

 

WHY THE GROWTH – PRICE STABILITY BALANCE MATTERS?

The RBI has often said that the stability in growth and prices matter a lot more for countries like India. The reasons are not far to seek. India with a per capita income of $2,500 has a lot of catching up to do to come to Asian and Latin American levels; forget about the US and Western Europe. Hence, for countries like India, growth is fundamental to its DNA, although such growth cannot be at the cost of price stability. For countries like India, the challenge is not just about managing growth and inflation. It is also about ensuring that investments are made in the right avenues with the highest ROI. For instance, India has a demographic advantage, so the best way to realize good growth is to step up investment in physical and social infrastructure. Also, the need is paramount to adequately leverage technology; especially newer idea like artificial intelligence (AI), machine learning (ML) etc.

As we discussed before, for countries like India, the fiscal policy being in sync with monetary policy is also paramount so that the impact of the efforts can be magnified. Also, in countries like India, there is a significant share of low-income population with large developmental needs. They are most vulnerable to supply shocks, and need  fiscal support which puts further burden on the limited budgetary resources. But, one more critical aspect in this entire story is how the central bank communicates.

HOW RBI HAS TWEAKED ITS COMMUNICATION STRATEGY

A very important aspect of the job of the RBI is to communication in simple and effective terms. Gone are the days when the central banker could get away by taking abstruse stuff. The RBI communication is important because it sets the expectations of the market. When it comes to inflation, it is not just the household inflation but the household inflation expectations that plays an important role. It is these expectations that decide how much families, spend, save, and splurge on consumer goods. Hence, the RBI not only manages the actual inflation numbers, but also the inflation expectations. The US has been a very steady and refined communicator of monetary policy intent to the public and the Indian financial system also needs to get on par with the Fed when it comes to communication the version. After all, monetary policy is the art of managing expectations. So, the RBI also uses its multi-point communication with the markets to give out a message on it intends to manage the inflation expectations in the future.

Indian has been the fastest growing large economy for 3 years in a row; and it may likely repeat the feat for the fourth year also. For India, it is as important that is maintains the GDP growth momentum; as it is important that it keeps inflation in check to boost the real GDP growth. That is why, for India and other similar South Asian economies, maintaining growth momentum, price stability and fiscal stability remains a daunting but essential challenge to contend with.

RBI has balanced growth and price stability rather well in the last few years; without allowing either of them to thrive at the cost of the other. One can complain about RBI policy action being too early or too back-ended; or too aggressive and too benign at times. What cannot be disputed is that RBI has managed to successfully juggle the twin objective of growth and price stability rather effectively.