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May need to frontload rate actions to tame inflation: RBI research paper – Economic Times

The Reserve Bank of India may need to frontload interest rate actions to anchor inflationary expectations, as the supply shocks to the economy have been repeated which central banks cannot look through as transient, according to a research paper from the RBI.

While the initial shocks looked to be transitory, the repeated shocks require frontloading of actions, it said.

“Repeated supply shocks trigger second round effects through cost-push, expectations, exchange rate and demand channels, warranting pre-emptive monetary policy action,” said the RBI research paper prepared by deputy governor Michael Debabrata Patra along with RBI officials Joice John and Deepak Kumar.

They said in the wake of the pandemic and now the war in Ukraine, the Indian economy faced repeated supply shocks. “At the current juncture, supply shocks are larger and unrelenting, carrying the risk of un-anchoring inflation expectations … With limited policy space, frontloading of monetary policy actions can keep inflation expectations firmly anchored, realign inflation with the target and reduce the medium-term growth sacrifice,” they wrote.

“The monetary policy can ignore the initial impact of an adverse supply shock as it lies outside its realm and remit, but it is essential for it to react to second round effects to avoid the generalisation of inflation. It is important to carry out an assessment of the life of the shock for an optimal monetary policy response,” the research paper said.

The views expressed in the article are of the authors and do not represent the views of the RBI.

Frontloading monetary policy actions may help improve central bank’s commitment to the inflation target. The RBI is mandated by law to keep retail inflation at 4% with a 2% margin at both sides. It raised the policy repo rate by 90 basis points in two phases since May. India’s retail inflation, measured by the consumer price index, jumped to 7.79% in April before easing to a shade over 7% in the following two months.

“The cost-push increase in inflation is much more painful than output losses. If the Indian basket of crude prices increases by 10%, inflation could increase by around 30 basis points at its peak, with GDP growth weaker by 20 bps. Hence, monetary policy tightening is required to push inflation back to target. The monetary policy reaction widens the output gap, compresses demand and thereby brings down inflation,” the paper said.

The authors argued that the required monetary policy response would be lower when there was a fiscal policy response to supply-side shocks. But the latter entails macroeconomic costs, including potentially a slowing down of medium-term growth.

According to the World Bank, the global median inflation is at its highest level since 2008. For advanced economies, it is at the highest level since 1982. This inflation surge draws its origins from a series of supply shocks – pandemic lockdowns, supply chain disruptions, elevated commodity prices and the war in Ukraine – exacerbated more recently by firming demand and shifts from services to goods and back.