RBI – Annual & Monetary Policy

Macroeconomic Outlook

The rebound from the COVID-19 induced slump has been sharper than anticipated and economic activity is expected to rebound strongly in 2021-22. Headline consumer price index (CPI) inflation receded into the tolerance band beginning December 2020. Core inflation pressures remain elevated, reflecting pass-through from higher crude oil and non-oil commodity prices, high fuel and other taxes post-COVID and increased operating costs. The evolving COVID-19 trajectory and progress on vaccination remain the key drivers of economic activity and inflation, globally and in India.

Section 45-ZA of the RBI Act, 1934 requires that the Central Government shall, in consultation with the Reserve Bank of India (RBI), determine the inflation target in terms of consumer price index (CPI), once in every five years. Accordingly, in a notification on March 31, 2021, the Central Government, in consultation with the RBI, retained the inflation target at 4 per cent (with the upper tolerance level of 6 per cent and the lower tolerance level of 2 per cent) for the 5-year period April 1, 2021 to March 31, 2026. The experience with successfully maintaining price stability and the gains in credibility for monetary policy since the institution of the inflation targeting framework in 2016 would be reinforced by the retention of the target and the tolerance band.¹ The experience during the COVID-19 period has testified to the flexibility of the framework to respond to sharp growth-inflation trade-offs and extreme supply-side shocks.

Key Developments since the October 2020 MPR

Since the release of the Monetary Policy Report (MPR) in October 2020, domestic economic activity has turned out to be better than anticipated on the back of a turnaround in gross fixed capital formation and a much shallower contraction in private consumption than in the preceding quarters of the financial year. The global economy is pulling out of the loss of momentum in Q4:2020, driven by multiple vaccine approvals, the launch of inoculation drives in many countries and the extension of monetary and fiscal stimuli. On the other hand, new mutants of the COVID-19 virus, second/third waves of infections, renewed lockdowns in many countries and uneven access to vaccines across countries continue to weigh on the outlook. The resurgence of commodity price inflation, supported by abundant global liquidity, has fuelled reflation trade in global financial markets. Despite the promise of continued accommodative monetary policies by central banks, bond yields have firmed up from very low levels, spurred by inflation concerns and expectations of stronger growth. Amidst stretched valuations, equity prices have become sensitive to the hardening of yields. In turn, exchange rates have become volatile, with capital outflows from emerging economies in early March interrupting their earlier ebullience on risk-on sentiments.

Crude oil prices jumped sharply on production cuts by the Organization of the Petroleum Exporting Countries (OPEC) plus and on anticipation of stronger demand. Non-oil commodity prices have risen substantially across the board, putting upward pressures on inflation in commodity importing countries. Gold prices eased from the highs reached in August 2020 on a stronger US dollar and expectations of economic recovery. While inflation is expected to remain subdued in advanced economies (AEs) and most of the emerging market economies (EMEs) on account of negative output gaps, the large fiscal and monetary stimuli and elevated commodity prices have raised inflation concerns over longer horizons in advanced economies and in the nearer-term in the case of EMEs.

Turning to the domestic economy, the gross domestic product (GDP) shrugged off the contractions of preceding quarters and moved into expansion zone in Q3:2020-21 (+ 0.4 per cent, year-on-year). High frequency indicators point to the growth momentum gaining strength in Q4 although the surge in COVID-19 infections in a few states in March 2021 imparts uncertainty to the assessment. The outlook for the agriculture sector remains bright, with higher rabi sowing, above normal north-east monsoon and adequate reservoir levels. Inflation receded into the tolerance band beginning December 2020 after breaching the upper threshold of 6 per cent for six consecutive months (June-November 2020). The late winter easing of vegetable prices that caused this softening has dissipated, however. In its February 2021 print, headline inflation firmed up again, with upside pressures getting generalised across constituents of core inflation.

Monetary Policy Committee: October 2020-March 2021

During October 2020-March 2021, the Monetary Policy Committee (MPC) met thrice. In the October 2020 meeting, the MPC noted that the revival of the economy from the unprecedented COVID-19 pandemic assumed the highest priority in the conduct of monetary policy. High inflation was seen as easing with the unlocking of the economy, restoration of supply chains and normalisation of activity. Hence, the MPC decided to look through the inflation spike and unanimously voted to keep the policy repo rate unchanged. It also voted to continue with the accommodative stance as long as necessary – at least during the current financial year and into the next financial year – to revive growth on a durable basis and mitigate the impact of COVID-19 on the economy, while ensuring that inflation remained within the target going forward.

In the run up to the December 2020 meeting, CPI inflation had increased to 7.6 per cent in October 2020 with food inflation surging to double digits across protein-rich items, edible oils, vegetables and spices on multiple supply shocks. Core inflation had remained sticky and was seen to firm up as economic activity normalised and demand picked up. At the same time, with the signs of economic recovery being far from broad-based and still dependent on sustained policy support, the MPC decided to maintain status quo on the policy rate and continue with the accommodative stance set out in the October resolution.

By the time the MPC met in February 2021, CPI inflation had declined to 4.6 per cent in December 2020 on the back of a larger than anticipated deflation in vegetable prices. The MPC noted the sharp correction in food prices but was concerned that some pressures persisted, and core inflation remained elevated. As the recovery was still to gather firm traction and continued policy support remained crucial, the MPC unanimously decided to keep the policy repo rate unchanged and maintain its accommodative stance.

The MPC’s voting pattern reflects the individual members’ assessments, expectations and policy preferences. The MPC’s unanimous vote on the policy rate in all the three meetings during October 2020-March 2021 was a reflection of the unprecedented pandemic and an unambiguous consensus on continued policy support.