RBI's Policy Talk on Tackling Inflation is Nothing But Optics

The RBI's policy decisions appear to prioritise banking profits and forex reserves over inflation control.

Neither money supply growth nor monetary policy has contributed anything towards inflation outcomes.

(Photo: The Quint)

Two openly stated principal objectives of the Reserve Bank of India (RBI) Monetary Policy are controlling high inflation and promoting growth. Two not-so-openly stated subsidiary objectives of the policy are protecting banking profitability and building foreign exchange reserves with orderly depreciation of rupee.

The Monetary Policy Committee (or MPC which is in no position to nudge the RBI in any direction other than what India's central bank wants) in its 6 December policy decided not to shake up the status quo regarding the inflation expectations and growth.

The RBI, however, as part of its Statement on Developmental and Regulatory Policies (which the MPC is not concerned with) decided to reduce the cash reserve ratio (CRR) from 4.5 percent to 4 percent, releasing about Rs 1.16 lakh crore liquidity to the banking system, which will add about Rs 7,000 crore to its profits annually.

The RBI, again as part of its statement, announced its decision to increase the interest ceilings on foreign exchange deposits to 'attract more capital inflows' which are expected to add to the foreign exchange reserves.

Even as the RBI is doing a lot to serve its subsidiary objectives, why is it not taking measures to serve its primary objectives?

Optics of Fighting Inflation

Typical of a central bank's unnecessarily complex speak – the MPC 'decided to continue with the neutral monetary policy stance and to remain unambiguously focused on a durable alignment of inflation' – changes in monetary base (currency in circulation plus demand deposits) does not really impact inflation in India.

The RBI monetary lever no longer nudges consumer price inflation (CPI) in the direction it wants to for two big reasons:

• First, inflation in India is largely a supply-side phenomenon (onion and tomato price gyrations, for example, in particular, and vegetable prices in general) with cost push provided by the government (by increasing minimum support prices) and/or measures taken by the government with respect to import and export to modulate supplies making significant impact

• Second, the RBI data confirm that massive expansion of digital payments with its multiplier effect determines the effective monetary base independent of the RBI’s control

The currency in circulation (CiC) has been witnessing a low growth for the last three years.

(Graphics: Kamran Akhter/The Quint)

The CPI inflation has persisted at high rates in the last three years despite no appreciable increase in CiC.

The demand deposits have witnessed somewhat higher growth.

(Graphics: Kamran Akhter/The Quint)

The CiC and demand deposits combined, the annual growth rates in the last three years turn out to be low and stable.

(Graphics: Kamran Akhter/The Quint)

Whatever policy measures the RBI takes or the policy stance it adopts regarding liquidity, it had very little or no effect on the monetary base/ money supply. Neither money supply growth nor monetary policy has contributed anything towards inflation outcomes.

The policy talk of ‘remaining focussed on a durable alignment of inflation with the target’ is nothing but optics.

Policy is Not Impacting Credit Growth Either

The rationale behind maintaining higher repo rate (interest rate charged by the RBI from banks to provide very short-term finance) is that higher rates discourage businesses and households from taking risky credit which bring down demand and, in turn, inflation.

In bad old days, traders and households used to take credit to buy foodgrains during the flush season (when crops were harvested) to stock it for sale at higher prices later. This classical pattern is more relevant for a supply deficit economy.

Over the decades, India has become a consistent surplus producer in cereals – wheat and rice – and, with no dearth of foreign exchange reserves and liberal import policy, adequate supply of oilseeds, pulses, and edible oils isn't a problem either. Consequently, there is no big demand for credit for stocking foodgrains.

It is the investment demand – setting up new factories and businesses, building new infrastructure and houses, and the like – which still needs credit.

Indian households demanded a lot of credit in the last two years for housing and other assets without worrying about interest rates. So much so that India witnessed record low net financial savings in 2022-23 which continued in 2023-24.

Credit growth reached dizzying heights in 2022-23 and 2023-24 in spite of the RBI raising the repo rate to the highest level of 6.5 percent. Recent slowdown in credit growth is on account of a slowdown in investment in housing, factories, and infrastructure – and not because of high repo rates.

The fact that the RBI lowered its estimates for 2024-25 growth from 7.2 percent to 6.6 percent without any change in its monetary policy, in a way, confirms that the factors causing growth lie elsewhere.

Protected Banks Profitability

A good proportion of housing and other loans have got linked to the RBI repo rate by now. Therefore, changes in repo rates make much impact on banks’ income from loans. The higher the repo rate, better the profitability of the banks. As the RBI did not reduce repo rate, banks’ high profitability remained protected.

In addition, reduction of CRR by half a percent would generate additional interest income of about Rs 7,000 crore on its deployment of minimum return yielding investment as the RBI pays no interest on CRR deposits.

The RBI policy would not only protect banks profitability but will also enhance it.

Post the Bimal Jalan Committee report of 2019, the RBI has to earn larger profits to provide the government decent surplus transfers and leave enough with the RBI to maintain cash earning reserves at the required level of 5.5 percent of the total assets. The RBI also wants to grow its foreign exchange reserves to ever higher levels.

Both these objectives are served well by the RBI net buying foreign exchange (higher buying to offset selling reserves at current prices to generate additional profits) with depreciating rupee by 2-3 percent every year.

The situation has been somewhat different in the last two months – the RBI has been forced to sell foreign currency reserves on account of factors not in its control such as FPIs selling stocks, US dollar strengthening post Donald Trump's victory, and so on.

From a monetary perspective, sale of foreign currency sucks liquidity. The objective of building higher reserves has temporarily taken a back seat though higher sales has boosted the RBI’s profitability with rupee depreciating more than the RBI might prefer.

The RBI Monetary Policy is not serving the objective of boosting growth with lower inflation. Instead, it is maintaining higher profits for banks and the RBI.

If the RBI wants to impact growth and inflation, it will have to do a lot of rethinking.

(The Author is the Chief Policy Advisor, SUBHANJALI, Author: The $10 Trillion Dream and Former Finance and Economic Affairs Secretary, Government of India. This is an opinion piece and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for the same.)