RBI wants govt help to help tackle liquidity, bats for 4% inflation band

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February 27, 2021 4:45 AM

Over the October 2016 to March 2020 period, headline inflation averaged 3.9%. Trend inflation estimates stood in the range of 3.8 – 4.3% for the flexible inflation targeting (FIT) period.

A disclaimer in the document stated that the report represents the views of the central bank executives who authored it, and not that of the RBI.Moreover, we expect growth to continue to recover and the output gap to close by Q1 2022. As growth normalises, so should policy.

The Reserve Bank of India (RBI) on Friday highlighted the need to increase sterilisation capacity to help tackle with surges in capital flows, with help from appropriate provisions in the Union Budget even as it endorsed the tolerance band of 4% (+/-2%) for inflation, saying it should be retained.

The RBI’s report on currency and finance for 2020-21 proposed sterilised intervention as an effective solution to resolve the trilemma of a fixed foreign exchange rate, free capital movement and an independent monetary policy. “Enhancement of sterilisation capacity may be necessary to deal with possible surges in capital flows in future,” it said.

While the activation of the standing deposit facility (SDF) can address the security availability constraint of the RBI for undertaking sterilisation operations, market-based sterilisation instruments are required to avoid misalignment of the operating target relative to the policy repo rate, it noted.

The fisc may also need to chip in here as adequate provisions for market stabilisation scheme (MSS) securities in the Union Budget every year may be necessary. This would help strengthen monetary operations of the RBI, consistent with the level of international reserves that is considered conducive for managing exchange rate volatility. “The precautionary requirements for building adequate buffers against global spillovers is a public policy objective, and not confined to the realm of monetary policy alone,” the report said.

The report noted the current inflation tolerance band should be retained for the next five years. “The international experience suggests that inflation targeting EMEs (emerging market economies) have either lowered their inflation targets or kept their targets unchanged over time. In India, however, the repetitive incidence of supply shocks, still elevated inflation expectations and projection errors necessitate persevering with the current numerical framework for the target and tolerance band for inflation for the next five years,” said the report. A disclaimer in the document stated that the report represents the views of the central bank executives who authored it, and not that of the RBI.

Over the October 2016 to March 2020 period, headline inflation averaged 3.9%. Trend inflation estimates stood in the range of 3.8 – 4.3% for the flexible inflation targeting (FIT) period.

The report explained the reasons that went into determining the upper and lower bounds of the tolerance band. Threshold estimates over a longer sample period work out to 6%, beyond which tolerance of inflation can be harmful to growth. On the upper tolerance limit, international experience suggests that countries with a large share of food in the consumer price index (CPI) basket tend to have higher inflation targets and wider tolerance bands.

On the lower tolerance limit for the inflation target, measurement errors warrant caution. Since inflation targets in advanced economies (AEs) remain unchanged at about 2%, notwithstanding persistent deflationary conditions, the lower tolerance band in India should not be less than 2%. This is also consistent with estimates of supply shocks, said the report. “Any attempt to bring down inflation below this level using contractionary monetary policy would dis-incentivise production activity as firms would not be able to pass on increased costs to final consumers,” it said.

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