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.
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