Dilemma for RBI

(MainsGS3: Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment.)

Context:

•  India’s retail inflation dropped to a three-month low of 6.77% in October when compared to the same month last year. 
• Further, the wholesale price inflation also dropped significantly from rising at double digit rates in earlier months to 8.3% in October. 

rop in inflation:

• Economists attribute the drop in inflation in October to a favorable base effect as retail inflation since the pandemic has been affected by lockdowns which served as a severe shock to the economy.
• Lockdowns affected the demand and supply sides in different ways which have led to unusual volatility in inflation figures since the pandemic. 
• Hence, it may be hard to compare inflation figures of the current year, in which normalcy has largely returned to the economy, with those from previous years marred by stringent lockdowns. 

Breaching target:

• Retail inflation has remained above the RBI’s target inflation range for ten months now, due to which the RBI has had to write to the government explaining why it failed to meet its inflation mandate. 
• Retail inflation at 6.77% is still above the RBI’s target inflation range, which is between 2% and 6%.
• So, despite the slight cooling down of inflation, economists expect the RBI to continue hiking interest rates over the coming months; the RBI may even want inflation to drop to around 4%.
• However, if inflation continues to fall, the challenge for the central bank will be to control the pace at which it slows down rate hikes. 
• This is because there is usually a time lag between monetary policy and its impact on inflation, which makes the setting of interest rates a tricky affair.

Not settled yet:

• It is unclear whether the drop in retail inflation in October marks the beginning of a sustainable downtrend in inflation figures as in the past, inflation figures have cooled down temporarily only to rise again in subsequent months. 
• Monetary policymakers are likely to be aware of this and may decide to wait and watch before signalling a decisive change in their policy stance.
• The RBI may also decide to keep the rate hike cycle going due to external pressures, particularly if domestic economic growth does not slump to alarmingly low levels as it raises rates.

Conclusion:

• The RBI needs to be cautious as inflation may be forced to raise domestic interest rates as well or dig deeper into its foreign exchange reserves in order to prevent a slide in the rupee against the U.S. dollar.