Who doesn't want growth?

The RBI, however, cannot use the growth argument to justify inflation

The preamble of the Reserve Bank of India (RBI) Act, as amended in 2016, inter alia states: “The primary objective of the monetary policy is to maintain price stability while keeping in mind the objective of growth.”

Defining “growth” itself could be a contentious issue. Many may argue that it should be sustainable growth, inclusive growth, equitable growth, and so on. While these are important issues requiring a detailed and informed discussion, let’s not get into this here and for the purpose of this article stick to a simple, common-sense meaning. According to the Oxford English dictionary, economic growth is, “The expansion of the output of an economy, usually expressed in terms of the increase of national income.” Broadly speaking, an increase in national income should generally translate into an improvement in the economic well-being of people and, therefore, no one should have any quarrel with supporting growth.

However, in conventional economic theory, there is a limit to which an economy can sustainably grow at any time, given its stage of development and absorptive capacity. Any growth more than the optimal level would lead to overheating of the economy, which may be as harmful, if not more, as an economy that is growing slowly. Overheating of the economy manifests itself in many ways including a rise in inflation.

Inflation affects different stakeholders in the economy in different ways, apart from resulting in entrenchment of inflation expectations. This is an important aspect, but it is not being dealt with here for want of space for this column. Suffice to say that high inflation mostly impacts the unorganised sector, people with fixed income with no inflation indexation, pensioners and people who keep their savings in bank accounts. Also, it can be safely stated that high inflation, beyond the optimal level, is not in the interest of growth. Of course, there could be a case where the economy has reached the stage of “stagflation”, where the growth could be low and inflation high at the same time. This is an even worse situation.

Illustration: Binay Sinha

Knowing what inflation rate to aim for is important for maximising the economic well-being of the public. Till before the onset of Covid, the US Fed, European Central Bank, and the central banks in many Western economies were aiming to increase inflation in their jurisdictions to avoid the spectre of deflation. Now they are struggling to contain inflation. We in India, on the other hand, have all along been worried about controlling inflation. Rightly so, going by our past experience. Estimating a desirable “optimal inflation rate” is not an easy task for any country, and the same will vary for different jurisdictions as also from time to time.

Coming back to the domestic scenario, section 45ZB (1) of the RBI Act states: “The Central Government shall, in consultation with the RBI, determine the inflation target in terms of the CPI [consumer price index], once in every five years”. In terms of this provision, the central government mandated the inflation target for the period 2016-21 as 4+/- 2 per cent. Later in 2021, the same target was kept for 2021-26. Note that the target is 4 per cent, with manoeuvring flexibility to the RBI of +/- 2 per cent.

It would be logical to assume that the inflation target set by the government in consultation with the RBI is an optimal inflation rate for the country’s economic growth. Presumably, the manoeuvrability range of +/- 2 per cent has also been thought through. There could have been various possible alternative formulations in this regard. For instance, the target could have been, say, just 4 per cent or 5+/-1 per cent, or there could have been any other formulation.

The flexibility relating to growth as hinted at through the preamble can’t provide an elbowroom beyond the flexibility provided in the mandated inflation target. The RBI cannot use the “growth” argument to justify an inflation rate beyond 6 per cent. The RBI should take the inflation target fixed under the Act, which has been fixed after consulting it, as the optimal inflation rate for achieving sustained growth.

The returns in real terms from bank deposits have been negative over the past two and a half years. During the preceding 26 months (up till May 2022), the CPI inflation has been 6 per cent or more in 15 months. There has been an argument that this inflation is transitory. However, apart from the fact that no one has any clue as to what would be the transition period, there is no statutory mandate to provide any relaxation for this. In case some more flexibility was to be provided, the government could have considered the same while revising the target in 2021 or even through amending the Act, if required.

There has been another argument that this inflation is largely on account of supply side disruptions and the monetary policy, which focuses on demand side management, can’t do much about it. While this, to an extent, may be a valid argument and it is for the government to take appropriate corrective measures to address the supply side issues. The RBI on its part may have no other option but to act according to the mandate if the inflation is expected to go beyond the target.

Some people have also commented that the RBI’s other functions like being a debt manager for the government and maintaining an appropriate exchange rate came in the way of taking a timely view on the interest rates. There is no statutory obligation on the RBI to keep the cost of borrowings low for the government or to maintain the exchange rate at a certain level. Further, section 45Z under Chapter IIIF (titled Monetary Policy) of the RBI Act settles the matter. It states: “The provisions of this Chapter shall have effect, notwithstanding anything inconsistent therewith contained in any other provisions of this Act”.

Right now, the Monetary Policy Committee (MPC) only decides the repo rate. Can fixing the repo rate alone achieve the mandated inflation target? The answer obviously is no. The MPC should be clearly mandated to also take a view on the desirable level of liquidity in the system and in fixing the reverse repo rate.

One of the reasons to introduce the system of a committee in the RBI Act, in 2016, with external members to determine the monetary policy, was to have wider expert deliberations on this important matter and not leave it just to the internal bureaucracy of the RBI to decide. It is time to critically review whether this has really worked.

The writer is a retired IAS officer, ex-chairman of Sebi, and was associated with the drafting of the 2016 amendment to the RBI Act