RBI: Crucial policy calls
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Robert Lucas and Thomas Sargent were proponents of the famous Rational Expectations theory. The theory said that if monetary or any policy is predictable, it ceases to have any impact on economic variables. If everybody knows that the central bank will act only when inflation crosses the defined threshold, it will be business as usual. However, if the central bank suddenly announces a major change, then the impact will be significant.Inflation outlookIn a business as usual scenario, there is little reason for one to expect any action from the Monetary Policy Committee. Inflation is well below the 4 per cent mark. It can be argued that inflation will cross the 5 per cent mark based on the global conditions as well as the policy actions taken by the government and OMCs. The question then is whether the MPC will wait for this number to materialise or act in anticipation by increasing the repo rate. But 5 per cent is within the range of 4-6 per cent; therefore, there is no need to take any pre-emptive action now. Therefore, the RBI projection of inflation is critical.Further, if the MPC acts this time, and the war ends leading to rollback of some measures, the present move will look hasty. If inflation rate does actually cross 6 per cent, can it be considered to be transitory or permanent?The general consensus hence is that there will be a status quo in repo rate, as inflation is low. The stance too may not change as changing to withdrawal of accommodation will be ambivalent — as liquidity is being provided by the RBI. A new term, such as ‘possible tightening’ or ‘calibrated tightening’ based on circumstances can be used, which is forward-looking. Such articulation can be more potent than action.Rational expectationsBut if the MPC wants to play a different game, going by the ‘rational expectations’ theory, it can go for a rate hike well before it is needed. Say, a 25 bps or even 50 bps hike will send a strong message that inflation will not be tolerated. This will spike bond yields, raising expectations of more rate hikes.Given exchange rate worries, an increase in rates will be positive for FPI investors in the debt segment. This can be a collateral benefit of increasing the repo rate though not a rationale. On the other side, raising rates now will mean higher cost of borrowing for the government. As the RBI is also the banker to the government, the latter has to keep this factor in mind.Higher rates will come in the way of future growth as investment becomes cautious, which in turn will lower aggregate demand in the system. Also as monetary policy should be forward looking, acting before the event carries more weight.The present economic environment which has been conditioned to a large extent by the global developments has made monetary policy formulation more difficult. Crude oil is one single factor which has upset calculations everywhere with inflation being the single most important threat. There is speculation also on whether the Federal Reserve under the new Chairman would be forced to raise rates.The situation back home is one typified by rising inflation and volatile currency at a time when the fiscal deficit could also go beyond the targeted number leading to higher government borrowing. In such a situation it would be tempting to raise the repo rate assuming that the higher inflation will materialise as the war drags on (with the El Nino effect adding to the inflation number in the second half of the year). The risk however is on the growth front as premature raising of rates could slowdown investment while not really affecting cost-push inflation. The upcoming credit policy becomes interesting, with these variables at work.The writer is Chief Economist, Bank of Baroda. Views expressed are personalPublished on June 3, 2026
