SNB-IMF Conference: RBI Governor says tight policy may be needed if inflation effects spread

Speaking at the SNB-IMF Conference, RBI Governor Sanjay Malhotra said on Monday that uncertainty is the biggest reality in monetary policy at the current juncture, and the emphasis is on a gradual policy approach under the Brainard Principle. A crucial concept in economics and monetary policy formulation, the Bernard Principle holds that policymakers should move gradually rather than aggressively when uncertain about how strongly an economy will react to their actions.

Describing anchoring inflation expectations as crucial, the RBI governor said that around 40 per cent of the country's CPI basket comprises food items. Malhotra also noted that dependence on monsoon increases the risk of supply shocks.

The central bank, he said, initially “looks through” the first impact of temporary supply shocks.

The RBI chief mentioned that a tight policy becomes necessary if second-round effects intensify. He said rising wages, production and transport costs can generalise inflation.

Central banks adopting meeting-by-meeting approach: Sanjay Malhotra

Emphasising that central banks are now adopting a meeting-by-meeting policy approach, he said that they have become more flexible after the pandemic and during the Russia-Ukraine war and are increasingly focusing on using high-frequency data. He also noted that the global situation remains fluid, with its macroeconomic impact still unfolding.

Greater emphasis is being placed on the difference between headline and core inflation readings, noted Malhotra.

'Fiscal policy necessary to deal with supply bottlenecks'

Stressing that fiscal policy from a government's side are essential in dealing with supply bottlenecks.

He also mentioned that the Monetary Policy Committee's April review had described the global energy shock as a "supply shock". A supply shock is a sudden disruption that changes the supply of goods or services in an economy. They matter as they can push inflation and growth in opposite directions simultaneously. Central banks closely track these conditions because supply shocks create difficult policy trade-offs.

The central bank chief also said that policy action is possible if supply shocks become embedded.

RBI’s 4% (+/- 2%) inflation target framework helps in handling shocks

Calling the price stability framework a "necessary anchor", the RBI chief said conventional economic models often fail, and both flexibility and credibility are necessary on monetary policy. Imports, buffer stock and anti-hoarding measures are essential to curb food inflation, he said.

Mentioning that average domestic inflation eased by around 2 per cent after inflation targeting was adopted, he said that RBI's tolerance band of +/-200 bps provides policy flexibility.

The RBI governor said that Inflation breaches during the coronavirus pandemic were ignored in a bid to aid economic growth.

His remarks came days after official data showed domestic retail inflation worsened to 3.48 per cent in April from 3.40 per cent in the previous month. A separate reading showed wholesale inflation accelerated hit a more than three-year high of 8.3 per cent, driven mainly by a steep increase in fuel, crude oil and metal prices.

The RBI chief said the central bank's three-quarter target horizon increases policy flexibility. Under India’s inflation-targeting framework, the RBI is required to submit a report to the central government if consumer inflation -- or the rate of increase in retail prices of select goods and services stays outside the mandated 2-6 per cent band for three back-to-back quarters.

Malhotra said that the policy framework needs to remain agile and nimble going forward.

The RBI has reiterated a ‘wait and watch’ approach on the current situation, he said. Conditions for tightening were clearly communicated in advance, he added.

Separately, the RBI withdrew a mandatory requirement for the Investment Fluctuation Reserve (IFR) -- a financial buffer aimed at protecting the RBI's balance sheet against losses arising from movements in market prices of its investments, effective immediately. This enables commercial banks to transfer their money kept as buffer to statutory or general reserves.