If markets want to assess the probability of the Reserve Bank of India’s (RBI) success in keeping a lid on inflation even as it fosters growth recovery, all they need to look is at the exchange rate.
Where does the rupee feature in the inflation mix for the RBI?
In its monetary policy report, the RBI said that in its updated quarterly projection model (QPM), the exchange rate is also considered as an input. “In terms of its structure, the augmented QPM model incorporates: a) fiscal-monetary dynamics, b) disaggregated fuel pricing (oil price, exchange rate and fuel taxes) and c) balance of payments and exchange rate interactions,” it said.
The RBI expects headline retail inflation to be around 5% for most part of FY22. The RBI has assumed a crude oil price of 64.6 per barrel and the rupee’s level at 72.6 to a dollar to arrive at its inflation projections.
The rupee has already weakened far ahead of that level now. It ended Wednesday session roughly 1% weaker at 74.56 to a dollar. The fall of the rupee has caused unease in the market. The combination of high commodity prices and a weakening exchange rate could put pressure on an already firm domestic inflation. A recovering domestic economy may mean imports will grow and a current account deficit would widen. That would put additional pressure on the exchange rate.
What’s more is that in all probability advanced economies would be the first to unwind their ultra-loose monetary policies. Once the US Federal Reserve signals unwinding, volatile capital outflows are inevitable from emerging economies such as India. “Another possible monetary policy headache that may lie ahead is the possibility of having to respond to capital outflows arising out of a possible strong US recovery, inflationary pressures and rising interest rates in the US that the IMF has highlighted in the World Economic Outlook of April 2021. Were that to occur, the RBI might well be placed in the unenviable position of having to cope with the ‘impossible trinity’, of balancing a second set of conflicting objectives, with domestic policy requirements and external policy requirements pulling in opposite directions,” said Alok Sheel, professor in macroeconomics at Indian Council for Research in International Economic Relations. The risks to inflation have only increased and it won’t be long before markets begin to realise it.
