The Reserve Bank of India’s Monetary Policy Committee (MPC) kept the key rate unchanged at 4% and decided to maintain an accommodative monetary policy. These decisions are on the expected lines. RBI Governor Shaktikanta Das has also unequivocally expressed the central bank’s willingness to help economic recovery.

“The Reserve Bank remains in ‘whatever it takes’ mode, ready to deploy all its political levers – monetary, prudential or regulatory. At the same time, the emphasis on preserving financial stability continues. At this point, our top priority is that the growth impulses be nurtured to ensure a sustainable recovery along a sustainable and stable growth path, ”said Das.

Despite these statements, the fine print of the MPC’s resolution points to worrying trends, including a threat of stagflation (low growth and high inflation) to the economy.

1. The Monetary Policy Committee’s growth projections are unchanged, but betray pessimism

The latest MPC resolution retained the GDP forecast for 2021-2022 at 9.5%, which had been projected at the June meeting. However, a look at the quarterly projections suggests that MPC members are more bearish on the economy than they were a few months ago. Here’s why. At its June meeting, the MPC forecast a GDP growth rate of 18.5%, 7.9%, 7.2% and 6.6% in successive quarters (June 2021, September 2021, December 2021 and March 2022) of the current fiscal year.

The latest projections have improved the June projection to 21.4%. This shows that the MPC believes that the second wave of Covid-19 infections did not do as much economic damage as expected.

The reason annual GDP growth remained unchanged at 9.5% is that growth projections for the second, third and fourth quarters were revised downward between the June and August meetings. The MPC’s resolution does not explain the reasons for this. But this is most likely due to damage on the demand side.

2. There is a significant upward revision in inflation forecasts, with a clear blame on oil taxes

As the RBI continues to argue that the current inflation phase is transient and driven by supply side issues, the real picture could be more complicated. Consider fuel prices, for example.

India’s basket of crude oil (COB) price was $ 69.7 per barrel on August 5. However, gasoline was selling at ₹101.84 per liter in Delhi, a level it failed to reach even when the price of COB exceeded $ 100 in the past.

The reason for this disproportionate increase in the price of petrol and diesel is the high level of central and national taxes – Union excise duties and state VAT have contributed ₹32.9 and ₹23.5 per liter at the price of gasoline in Delhi.

In the absence of a significant drop in crude prices even after the OPEC + deal, the MPC’s resolution put the responsibility of controlling inflation at the center and states are reducing taxes on petroleum products.

“With crude oil prices at high levels, a calibrated reduction in the indirect fiscal component of pump prices by the Center and the states can help significantly reduce cost pressures,” the resolution says.

3. Is it time to challenge assumptions about India’s potential growth rate?

The fact that the pandemic has disproportionately affected labor (in the labor-capital binary) and the informal sector (in the formal-informal binary) is now well accepted.

Whether and to what extent the uneven burden of the pandemic will hurt growth prospects is a question on which there is less unanimity. While a group of economists such as Credit Suisse’s Neelkanth Mishra believe the damage may be minimal as India’s growth has always been driven by the top of the pyramid, many others have pointed to potential obstacles to growth. aggregate demand resulting from income compression of the poor, who have a greater marginal propensity to consume – consumption per unit of income increase – than the rich.

This debate is extremely relevant for judging the effectiveness of monetary policy as an engine of growth, as pointed out by Pranjul Bhandari, chief economist for India at HSBC Securities and Capital Markets India in a dated research note. August 2.

“Monetary policy is a countercyclical tool. It plays an important role in closing the output gap. But it is not an engine of potential growth. The RBI would be well served to think carefully about when the output gap is likely to close and start to gradually narrow before that, as transmission takes time in India, ”she wrote.

The International Monetary Fund defines the output gap as “an economic measure of the difference between an economy’s actual output and its potential output”. Potential output is defined as “the maximum amount of goods and services that an economy can produce when it is most efficient, ie at full capacity”. In monetary policy parlance, potential output is also seen as the limit that can be reached without fueling inflation.

Bahndari highlighted the threat of a reduction in potential output in a research note in May itself. “We were already worried about the scars the first wave of the pandemic would leave behind – a weak financial system and growing inequalities. We had estimated that they would reduce India’s post-pandemic potential growth from 1ppt to 5%. We are concerned that these scars will worsen further with the second wave, ”she wrote.

When one reads the fact that India’s growth rate was below 6% even in the year before the pandemic, there is all the more reason for concern.