RBI bats for easy monetary policy till output gap remains negative

The key issue is to estimate the output gap, RBI said in its monthly bulletin, because Inflation becomes more sensitive with the output gap closing and moving into positive territory.

“Under current macroeconomic conditions, still weak demand conditions are flattening the Phillips curve in India, providing some manoeuvring room for monetary policy to support the recovery without being hemmed in by demand-driven inflation concerns,” RBI said.

It underscored the need for vigilance, as the curve steepens with the output gap closing and moving into positive territory, causing upside risks on the inflation front to rise, it added.

Output gap remains negative till the time actual output in an economy is lower than its potential.

At the October monetary policy, the Monetary Policy Committee continued with the accommodative policy stance despite concerns over price rises, which it maintained as “transient”.

The Indian economy was in a downturn when the pandemic struck. The GDP slowed by 24.4% in the first quarter after the pandemic struck and contracted by 7.3% for the whole year with a negative output gap. The Indian economy is projected to grow at 9.5% in FY22.

“Inflation is sensitive to the output gap and this finding is statistically significant, confirming the existence of the Phillips curve in India,” RBI said.

The Phillips curve, developed by economist AW Phillips, shows a stable and inverse relationship between inflation and unemployment or output. It states that higher output leads to higher prices and wages and creates more jobs and less unemployment.

However, the economic debate over the existence of Phillips gained momentum following the long phase of slack economic activities and negative inflation in different geographies world over.

RBI said that the Phillips curve in India is recovering from a period of flattening lasting more than six years, i.e., from 2014.

The inflation process in India has become increasingly sensitive to forward-looking expectations. The slope of the Phillips curve has been declining with the anchoring of inflation expectations, the central bank observed.

“Our results also point to threshold effects – as the output gap becomes positive, inflation becomes increasingly sensitive to it,” said the RBI.