4-point battle plan for RBI

Times of India, May 14, 2022

As the Indian economy struggles to recover from the pandemic, it is facing another obstacle in the form of high and rising inflation. Keeping inflation low and stable is the legal mandate of the Reserve Bank of India under the inflation targeting (IT) framework. It is therefore worth asking: why is inflation so high, and what should be done differently to ensure it comes down and stays down?

Consider the first question. In recent months, the Russia-Ukraine war and China’s lockdowns have pushed up the prices of critical items including crude oil, edible oils, and fertilisers. On top of that, for the first time in four decades, India is now “importing” high inflation from developed economies such as the US and Europe. Without doubt, these external developments have exacerbated India’s inflation. But they are not the cause of the problem.

The real cause of the problem lies closer to home. Inflation is high today because underlying pressures have been building up for years, and the RBI, despite its legal mandate, has not acted in time to stop them.

Since the start of the pandemic in March 2020, consumer price index (CPI) inflation has averaged 5.8 percent. This implies that inflation has been close to the 6 percent upper threshold of the RBI’s target band, despite an unprecedented collapse in demand. For the first three months of 2022, inflation has consistently exceeded the 6 percent upper limit. The wholesale price index (WPI) has been increasing at an even faster rate, averaging 13 percent since April 2021. This is the highest WPI inflation in more than two decades. This matters for the CPI target because persistent increases in wholesale prices get passed on to retail customers with a lag of a few quarters. Of particular concern has been the recent spike in WPI food inflation, which is now translating into high retail food prices.

In other words, the warning bells about growing inflationary pressures have been ringing loud and clear for a while now. Yet, despite being an IT central bank, the RBI has not been paying much heed to these alarm bells. On the contrary, it kept arguing that inflation was a temporary problem. This was presumably based on the assumption that inflation would disappear when the pandemic subsided, that the supply constraints--both domestic and international, would soon abate, and that global inflation was also temporary. The RBI’s inflation projections reflected this assessment. Over the past few months, its forecast of CPI inflation for 2022-23 remained in the range of 4.5 - 5.7 percent.

It is quite clear now that inflation is not a temporary problem. The war in Ukraine is unlikely to end soon, and even when it ends, the international sanctions on Russia will remain for some time. The lockdowns in China are getting worse by the day. Even the US Fed has now acknowledged that inflation is not a transient phenomenon and has been forced to act aggressively. In all likelihood, the era of low global inflation is now over.

Meanwhile, in India, with inflation predicted to subside on its own and remain well within the band, the RBI did not feel the need to act to contain it. Instead, its “accommodative” policy has trapped the economy in a vicious circle. With interest rates falling and inflation rising, real interest rates have been falling sharply, intensifying excess demand, feeding inflation, thereby further reducing real rates. During the first three months of 2022, real 91day Tbill rates fell to the exceptionally low rate of -2.6 percent. Clearly, the RBI needed to act on time to stop this dynamic.

This brings us to the second question: what should the RBI do differently to address this problem?

First, it needs to clearly communicate that it is serious about inflation and will do whatever it takes to bring inflation down to the target level over the next few months. This is important for anchoring inflation expectations. If the public expect inflation to keep rising it will become even more difficult for the RBI to tame inflation.

First, it maybe argued that the increased capex spending by the government since last year has not resulted in the desired “crowding-in” of private sector investment which continues to be sluggish.

Secondly, the RBI needs to stick to the operating procedure outlined in law, and announce monetary policy changes in a predictable manner. This is crucial for restoring its own credibility as an IT central bank. The surprise May 4 announcement, when the repo rate was suddenly raised by 40 basis points, is exactly the kind of policy action that the RBI should avoid. A sudden reaction like this sends a signal that the RBI has lost control of the situation and that after ignoring inflation for too long, needs to overcompensate. This kind of an action undermines rather than builds confidence.

Third, any decision to raise the policy rate must be accompanied by an inflation forecast that justifies the rate action. Releasing credible inflation forecasts instils confidence about the capability of the RBI to do IT.

Finally, the Monetary Policy Committee (MPC) should be restored to its rightful role as the overseer of policy decisions. Over the past few years, the RBI has essentially bypassed the MPC, thereby losing a vital “reality check” on its forecasts and actions.

The inflation problem in India has reached worrisome proportions. As a result, the adjustments needed are more painful than they would have been if the RBI had acted on time. But late is better than never. The RBI now needs to be decisive and resolute in pursuit of its inflation target. The future of India’s economy, and the livelihood of its people, depend on it.

Question of timing

Indian Express, May 31, 2022

The Reserve Bank of India normally makes policy announcements on a well-defined schedule. But on May 4 it unexpectedly tightened monetary policy, increasing its policy interest rate and reducing liquidity in the banking system. Markets were taken aback by the announcement, with the 10-year government bond yield jumping by 25 basis points to reach 7.38 percent.

Why did the RBI do this? Even after the Governor’s careful explanations, the answers remain unclear.

At one level, the answer is obvious: inflation pressures are rising. Since the last MPC meeting of April 8, headline CPI (consumer price index) inflation has gone up from 6.1 percent to 7.0 percent, and the forthcoming inflation numbers are expected to be even worse. Clearly, the RBI had to respond. So, it raised the policy repo rate by 40 basis points to 4.4 percent and increased the cash reserve ratio by 50 basis points to 4.5 percent.

This explanation however does not seem entirely adequate, because nothing fundamental has changed since the last policy meeting of April. Even back then, it was obvious that inflation pressures were rising. The wholesale price index (WPI) was already in double digits, inflation in the US and Europe was increasing, commodity prices were spiking owing to the Russia-Ukraine war, and supply chain constraints were tightening, as China imposed severe lockdowns to deal with a resurgence of the Covid-19 pandemic. But the RBI did not think that these pressures warranted a policy tightening.

What made the RBI change its mind? Under the Inflation Targeting framework, the central bank’s thinking is typically revealed by its inflation forecast. If it projects that inflation will be above target for some time, this implies that the central bank is concerned about rising prices and will be taking action to bring inflation down. In the last Policy Review, the RBI projected that inflation would abate to 5 percent by the end of the fiscal year, somewhat higher than the 4 percent objective but not unduly so, thereby explaining why the central bank saw no need to tighten at that time.

Presumably, the RBI now thinks that the inflation pressures will either be more intense or more durable than it had earlier expected. And presumably, the RBI felt that its policy stance was now “behind the curve”, meaning that urgent action was needed to quell these pressures. Otherwise, it would have waited till the next MPC meeting on June 8 to increase the repo rate. But it is impossible to know whether this was really the motivation, as the RBI didn’t release a revised inflation forecast—and because other explanations are also possible.

One possibility relates to the exchange rate. The US Federal Reserve was expected to announce a 50 basis point increase in interest rates later in the day of May 4. So, it is possible that the RBI wanted to jump ahead of this announcement by announcing its own 40 basis point rate increase, maintaining (more or less) the interest differential against the US dollar and thereby keeping the dollar-rupee exchange rate relatively stable.

It's not obvious why exchange rate stability would be a priority for the RBI. After all, its legal mandate is to achieve an inflation target, not an exchange rate objective. But the RBI does seem determined to limit the rupee’s depreciation. The April 8 statement highlighted that India's foreign exchange reserves had increased to US 607 billion at the end of 2021-22. In contrast, the May 4 statement mentioned that India’s foreign exchange reserves now amount to US 600 billion, a decline of US 7 billion. So, clearly the RBI has been intervening in the foreign exchange market to stem the rupee depreciation. It therefore appears plausible that the unexpected increase in the policy rate was done to defend the currency against further depreciation pressures.

So, there are two potential explanations for the RBI's sudden move. Both have rationales, but both also have costs. Consider the first possibility, that the RBI has now radically revised its inflation forecast (without of course releasing the same). Inflation targeting works best if monetary policy is predictable, with interest rate actions being announced on a regular schedule, based on clearly-explained inflation forecasts. On the contrary, sudden moves convey the message that the RBI is getting worried that it is no longer in control of the inflation situation, which is hardly a reassuring signal to send to the markets.

Next, consider the possibility that the RBI wanted to keep the exchange rate stable. The problem is that India is facing an adverse terms of trade shock in the form of rising oil prices, which is putting pressure on the current account deficit. If the RBI allowed the exchange rate to depreciate in response, this would alleviate the current account deficit. Perhaps more importantly, depreciation would help the nascent recovery by ensuring that exports can continue to grow, despite the difficult international circumstances. And there is the additional problem that targeting the exchange rate violates the RBI’s legal mandate.

The RBI now faces a difficult task in the months ahead. At the broadest level, it needs to address the costs of its surprise announcement by reinforcing the credibility of the inflation targeting framework. Specifically, it will need to focus – and be seen to focus – squarely on its inflation target, rather than exchange rate or other objectives. And it will need to convince the public that it is actually trying to get inflation under control.

To do this, it will need to continue to tighten policy – but in a gradual, predictable and transparent manner.