On June 8, the Reserve Bank of India increased the policy repo rate by 50 basis points. This is a step in the right direction. There is an ongoing inflation crisis in the country and the central bank seems to have finally woken up from its slumber. This however raises deeper questions about inflation control in India.
This is the second time in the last 15 years that India has faced an inflation crisis and the RBI has been caught napping. The first time was right after the 2008 Global Financial Crisis. One big difference between these two episodes is that the RBI is now an inflation targeting central bank. IT was implemented precisely to help avoid a situation of high and volatile inflation. So what went wrong, and what lessons can be learnt from the current crisis?
Let’s first understand how the RBI missed the inflation bus. The inflation problem has been brewing since 2020. During March-Dec 2020, CPI inflation exceeded the 6% upper limit of the RBI’s target band, for three quarters in a row. According to the RBI Act 1934 (amended 2016), this is considered a failure of the RBI to meet the inflation target. The RBI is required to write a report to the Central Government explaining the reasons for the failure, remedial actions to be taken and the estimated time period within which the target will be achieved. At the time however the RBI succeeded in dodging this accountability, citing data problems aggravated by the lockdown. This was also the time when the pandemic was in full swing and central banks all over the world were rolling out easy monetary policies. Hence the analysts and experts (barring a few) in India also did not question the RBI’s overlooking of the inflation problem.
Moving on to more recent times, the Russia-Ukraine war and persistent supply chain bottlenecks have once again pushed CPI inflation above the 6% level starting Jan 2022. More worrisome has been the persistent increase in WPI inflation which has steadily gone up from 10.7% in April 2021 to 15% in April 2022, the highest level in three decades. Wholesale inflation impacts retail prices with a lag. This implies that CPI inflation will continue to increase.
The table below summarises the RBI’s response to this surge in inflation. Even as CPI inflation kept rising and WPI inflation reached alarming levels, the RBI continued to underestimate inflation. It stuck to an accommodative stance and refrained from increasing the policy repo rate. This shows that the RBI did not consider inflation a serious problem till May 2022. Even though no new information surfaced between April and June, the RBI increased interest rates by a steep 90 basis points in a little more than a month, between May 4 and June 8.
This shows that the RBI was behind the curve and is now trying to overcompensate. This does not instill confidence about how inflation is being managed despite RBI being an inflation targeting central bank.
This episode raises deeper questions about the working of the IT framework and highlights some important lessons.
First of all, in the IT regime, the Monetary Policy Committee is responsible for forecasting inflation, setting the policy rate as well as deciding the monetary policy stance to help keep inflation within the target band. We need to ask why did the MPC fail in anticipating the surge in inflation months ahead of time and what reforms are required to help avoid a similar situation going forward.
Secondly, and a related point, it seems the MPC is not using the power that it has been vested with by the law. For instance, a critical feature of an effective committee is dissent by its members. This reflects diversity of opinions, one of the main reasons we have a committee now looking into inflation. It is remarkable that despite the uncertainty of the underlying macro environment, there has not been a single dissent in the MPC as regards the policy rate, for several months. Lack of disagreement raises questions about the MPC’s efficacy.
Third, the greatest contribution that monetary policy can make is inflation control. For this to happen, all other objectives of the RBI must be delegitimised, including, ensuring low-cost borrowing for the government, and exchange rate management.
Finally, a key element of IT is accountability. We need to create an environment where it is costly for the RBI to stray from its primary objective of inflation control. For example, when CPI inflation exceeds 6% for three quarters in a row in 2022, the RBI must explain where it went wrong and what steps are being taken to remedy the situation.
In India, inflation harms the poor the most, and hence it is directly relevant for politicians trying to win elections. In such a situation, the best thing that the RBI can do is to deliver a predictable 4 per cent CPI inflation for decades so that economic policymaking can get back on track and firms and households can start planning for the future. Both the RBI and the government must therefore learn from the current inflation crisis and further strengthen the IT framework so that India does not face a similar episode of high and volatile inflation, the third time around.
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