AFA DAILY READINGS- 21/01/2019


RBI: On the horns of a dilemma

[MAINS OPTIONAL SUBJECT- ECONOMICS]


Must the central bank cut interest rates or only change its stance in the February policy review?

After changing the stance of the monetary policy in the October review meeting to ‘calibrated tightening’ from ‘neutral’, the Reserve Bank of India (RBI) under Shaktikanta Das may choose to change the stance back to ‘neutral’ again in the February review meeting, after retail inflation grew at the slowest pace in 18 months. December retail inflation came in at 2.19% on the back of softening food and fuel prices.

  • The monetary policy committee (MPC) of the RBI decided to keep the key interest rate unchanged at 6.5% in the policy review meeting in December.
  • If the RBI decides to lower the interest rate, a change in stance to ‘neutral’ will only be natural. A neutral stance would mean there is a scope for interest rates to move either way, as opposed to calibrated tightening which means rates can only go up.

Inflation assessment:

  • Even if the RBI is guided by headline inflation numbers for policy-making purposes, the divergence in major components of inflation creates the dilemma of whether to lower the rate or not.
  • RBI Governor acknowledged that the divergences and volatility among the components becomes a challenge for assessment of inflation. Some of the major components like inflation in food, fuel, and inflation excluding food and fuel, have shown wide divergences.
  • Food inflation has turned negative since October 2018 and fuel inflation has been highly volatile, inflation, excluding food and fuel, remains sticky at close to 6%.
  • Core inflation hardened to 5.4% from 4.9% last month, it should reverse with oil and commodity prices coming off. It has been tracked January inflation at 2.7% with food deflation persisting.

Reason for dilemma: Dilemma is the upcoming Budget on February 1. Traditionally, election years have seen only a vote-on-account in which no major announcements are made. However, this year could be an exception as Finance Minister Arun Jaitley indicated at a recent event.

 

Possibilities: There is the expectation of a major announcement from the government for the rural economy due to the stress faced by the farm sector. If that happens, then RBI would like to watch for implications on inflation as well as on fiscal deficit.

Conclusion: Even though all above, there are some distressed sectors like agriculture, MSMEs which are in need of desperate support from the government. The current situation specifically says liquidity is required in the economy, distress sectors need to be taken care of, banks need to expand credit, and there is a resource constraint from the government side. So, there is a possibility think to a scope for expansionary policy when inflation is under control.


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