India’s central bank should lead the policy easing cycle that its economy needs

Indian macro policy has been tight at a time when domestic demand from households, firms and the government shows signs of weakness. There are three clues that tell the story.

First, the growth in gross domestic product (GDP) has been declining for three quarters in a row. Second, core inflation has been well under control in the 12 months to November 2024. Third, the current account shows no signs of excess domestic demand that could be spilling over into higher imports.

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The tricky question is how macro policy can be eased this year. There are times when the evidence is so stark that both fiscal as well as monetary policy can be either eased or tightened at the same time. One recent case was when the pandemic struck five years ago. There was a compelling case for coordinated action to support domestic economic activity.

The other case was in the early years of the previous decade, when double-digit inflation combined with a widening current account deficit created a compelling case for coordinated action in New Delhi and Mumbai to cool down the economy.

How the combination of policy dials can be turned this time around is a more complicated question. The government has less freedom to ease fiscal policy at this point in time.

It has already publicly committed itself to a plan of bringing down the annual fiscal deficit by the end of fiscal year 2025-26, and then managing its finances in a way that reduces the ratio of public debt to GDP. The upshot: a meaningful fiscal stimulus is unlikely.

What about monetary policy? Headline inflation has been on the higher side of the target range for at least a year now, other than when it fell sharply in July and August, and then when it shot through the upper limit of the formal inflation target in October. This has obviously made RBI wary of price pressures.

A situation such as the current one—in which headline inflation drifts away from core inflation— muddies the waters for decision makers. The question right now is how the two measures of price pressures in the Indian economy will align in the future. Will core inflation rise to come closer to headline inflation? Or will headline inflation drop to approach core inflation?

Much depends on the underlying economic dynamics. One reason for worry is when high food prices lead to demands for higher wages from households that want to protect their purchasing power.

The other is when companies decide that they can safely pass on higher input costs to consumers without losing them. In other words, will higher food prices spill over into the rest of the economy through either wage demands or corporate pricing power?

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In recent monthly reviews of the Indian economy, RBI has indicated that price shocks have hurt consumer demand. It has also flagged concerns that there are signs of inflation spilling over from one sector to another—from edible oils to processed foods, for example.

It is also likely that higher costs of living have led to higher wages in personal services provided by cooks, household help and so on. “The hardening of input costs across goods and services and their flow into selling prices needs to be watched carefully," the Indian central bank said in its November review of the economy.

This column had argued before the December meeting of the monetary policy committee (MPC) that there is a compelling reason for monetary policymakers to look through the temporary food price spikes because of erratic rains or heat waves, at least till there are no signs of generalized price and wage pressures in the economy.

In his published comments at the end of the MPC meeting in December, Ram Singh (one of the two external MPC members who have voted for a rate cut) pointed out that the impact of food inflation on core inflation has significantly reduced in recent years. This is largely because of changes in the way wages and prices are being set in India, he said.

It is also likely that households and firms in the private sector have begun to look past one-off price shocks in specific food items because of a growing trust in the ability of RBI to keep overall inflation under control.

Such an increase in the credibility of the central bank would mean that food price shocks do not quickly translate into higher core inflation via wage demands from households or price hikes by companies.

The recent decline in the rupee against the dollar is mostly a result of a global rally in the US currency. However, it is also true that RBI has lately allowed the rupee to depreciate after several years of keeping it relatively steady. A speculative question: Is that an advance signal of a change in strategy at RBI under a new governor?

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