The Reserve Bank of India is an inflation targeting central bank. It is legally mandated to keep inflation in check. Yet the RBI has persisted with its easy monetary policy, even as inflation pressures have increased. We need to understand why, and what could be the repercussions.
Let's first ask, is inflation a problem in India? Indeed, it is. For most of the past two years, CPI (consumer price index) inflation has been hovering close to the 6 percent upper threshold of the RBI’s target band. Inflation averaged 6.1 percent during the pandemic period (April 2020 to June 2021), despite a massive collapse in aggregate demand. It then dipped somewhat as food prices eased, but underlying inflation (i.e., core inflation, excluding food and fuel items) has remained around 6 percent for the last twelve months. Then in January 2022, as food prices recovered, headline inflation once again crossed the upper threshold of the RBI's inflation targeting band.
Inflationary pressures do not seem to be diminishing either. Instead, they continue to build up. The standard measure of inflation "in the pipeline" is WPI (wholesale price index) inflation, since price increases at the wholesale level tend to translate into retail inflation in due course. And the WPI is sounding a loud alarm. Between April 2021 and February 2022, WPI inflation averaged 12.7 percent, the highest in more than a decade.
The problems do not stop there. Russia’s invasion of Ukraine has resulted in a sharp increase in global commodity prices, including prices of crude oil, edible oils, and fertilisers. At the same time, a resurgence of the Covid-19 pandemic in mainland China and Hong Kong has led to shutdowns that will further constrain supplies of raw materials. Even if the war and the pandemic in China both subside soon, their effects will not. Sanctions on Russia are likely to remain for some time, while it will take a while for China to clear the backlog of orders that the shutdowns have caused.
Indian firms are already adapting to this situation, passing on the commodity price increases to retail prices. We have reports of double-digit increases in the prices of consumer goods (FMCG) as well as in the real estate sector. Even though the government continues to suppress domestic pump prices, prices of petrol, diesel and cooking gas have gone up in major cities.
Standard economics gives us a guide for how central banks should react in a situation like this. It says that monetary policy should accommodate the first round of commodity price increase, but only under certain conditions, notably that inflation is initially on target, and expectations are firmly anchored. But neither condition holds at present. Inflation is already too high, and so are expectations. As of January 2022, 68 percent of households surveyed by the RBI expected prices in the 1-year ahead period to increase more than the current rate, up from 63 percent one year ago; more than 57 percent households expected cost of services in the 1-year ahead period to increase more than the current levels, up from 51 percent one year ago.
In some quarters, an argument is nonetheless being made that monetary policy should not be tightened when inflation is driven by supply-side factors, as it can adversely impact growth. This is fallacious; it has things exactly backward. When there are supply constraints, using easy monetary policy to boost demand is not going to boost output. It will only create a situation of excess demand, pushing up prices even further. And if firms are expecting high inflation, this will send things into a vicious spiral, as they will increase their prices even more in advance of any input price pressures.
Surely the RBI is aware of all of this. So why is it still not acting on it? To answer this let’s take a step back and look at what is happening globally.
The RBI is not the only central bank that is not reacting to inflation. In the US, the Federal Reserve has been slow to raise rates even as inflation has reached a four-decade high. The ECB in Europe has been even slower to react. The problem seems to be that governments all over the world are worried about growth. They are hoping that central banks can somehow solve this problem, since government debts are at exceptionally high levels. Until governments accept that reviving growth is their responsibility, not that of the central banks, and especially not when inflationary pressures are on the rise, central banks will not be able to focus on inflation.
In India, monetary policy also suffers from a strong fiscal dominance. As a result, not only is the RBI expected to support growth, it is also expected to keep the government’s borrowing costs in check, which is in direct conflict with its inflation targeting objective.
What are the repercussions of the RBI ignoring inflationary pressures? A decade ago, we were in a similar situation where inflation had started increasing but the RBI delayed its response because it was focusing on growth. When inflation subsequently took off, it reached double digits and the RBI had to raise interest rates aggressively to bring it down. That was a very painful adjustment. We do not need a repeat of that episode now. In other words, we need to recognise that high inflation is the real threat to growth, not a prudent monetary policy tightening.
In addition, if the RBI does allow inflation to take off, there will be long-lasting repercussions for the credibility of the RBI. Inflation control requires anchored inflation expectations. But if the public see the RBI consistently ignoring inflation, expectations can rapidly get unanchored and then it becomes very costly to bring inflation down.
In summary, inflation is best addressed by the central bank using monetary policy, not by the government adjusting taxes. The RBI needs to urgently revisit its inflation forecast and its monetary policy stance in order to avoid potentially painful adjustments down the road.
