Addressing students at Princeton University in the US on April 18, Malhotra said monetary policy has a primary role to play in “preventing this entrenchment” in such a situation through its influence on inflation expectations rather than through blunt demand compression.
The war, particularly disruptions around the Strait of Hormuz, has severely dented the supply of crude oil and natural gas, and fertilisers, which could increase imported inflation. West Asia contributes about a fifth of India’s imports and half of its oil imports, besides two-fifths of total fertiliser imports.
“The appropriate monetary policy response to such a supply shock is to look through the first-round effect to the extent that it does not feed into second-round dynamics,” said Malhotra. “Second-round effects are the real concern. They can materialise if the supply chain disruptions continue for long. Then, what began as a supply shock can become embedded in the general price level,” he said in a speech, titled ‘RBI’s Role in India’s Growth and Navigating Global Challenges’.
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The central bank shared a copy of the speech late Monday.
“In uncertain times such as this, it is important to be agile and nimble, maintaining a broad policy stance, and avoid making firm commitments of the future path of policy (sic),” he said, adding that the RBI has become more data dependent to help it guide through this situation while it continuously reassesses the balance of risks.
Malhotra also emphasised the prudent fiscal management in maintaining price stability in such a situation when supply side factors are playing a large role in inflation. While the government took steps to boost local oil and gas production after the Iran war broke out, it along with oil marketing firms has largely absorbed the price pressures in oil, helping prevent a major impact to consumers.
RBI has been maintaining a neutral stance for the last few policy cycles. This has preserved the central bank’s flexibility to respond as the inflation-growth dynamics evolve.
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The governor explained that India’s decade-long experience with a flexible inflation targeting regime helped the country to successfully navigate through persisting shocks—from the pandemic to the Ukraine war.
“Since uncertainty is central to monetary policy, the broader guiding principles of our policy-making do not change,” he said. “It is only their application, which changes,” he said, stating that the first principle is to prioritise robustness over optimality.
Malhotra said policymakers try to understand the risks emerging from the uncertainties, assess their probabilities, quantify their impact, and then devise a policy that maximises best policy outcomes of price stability and growth.