Judging the RBI by the wrong rule

Business Standard August 17, 2026

According to several commentators, the Reserve Bank of India needs to bring about radical changes in its monetary policy conduct. At a minimum, it must change its rate-setting approach. It might even need to abandon inflation targeting altogether. Are these claims valid?

Their argument, in essence, runs like this. Ever since the RBI adopted inflation targeting, real interest rates have stayed far too high, thereby undermining economic growth. This has happened because the RBI follows a flawed approach: it sets rates on the basis of past inflation, even when price pressures are already on the cusp of dissipating.

These are strong claims, and they deserve careful scrutiny. Let’s start with the main one: inflation targeting has biased the RBI toward a tight monetary policy. The data says otherwise.

Since the RBI adopted inflation targeting in 2015, the real rate (nominal repo rate minus headline CPI inflation) has averaged just 1.1 percent (see chart). This is strikingly low for a country growing as rapidly as India. It is also below the neutral rate that the RBI itself estimates at 1.5-2 percent. And it has been too low to achieve the 4 percent inflation target, given that inflation, since 2015, has averaged 5 percent.

Why, then, have commentators been complaining about high real rates? That is because some periods have seen real rates exceed 2 percent, including recently. In 2025-26, the real rate hit 3.5 percent.

Could this have occurred because the RBI's framework focuses only on past inflation, as the commentators claim? Vaishali Garga of the Boston Fed and I analysed the data thoroughly (Garga V. and Sengupta, R, "Do Actions Match Words? Reassessing the Taylor Rule in an Emerging-market Context", Federal Reserve of Boston Working Papers, August 2026). We found that the RBI does consider past inflation when setting the repo rate. But it also puts considerable weight on its inflation forecast-exactly what inflation targeting requires.

The problem, then, is not the framework. It is the accuracy of the forecasts. If the inflation forecast is too high, the real rate will be too high as well, and this is what happened recently. In its April 2025 monetary policy statement, the RBI’s forecast of CPI inflation for 2025-26 was 4 percent. Actual inflation came in at 2 percent. The RBI did not revise its forecast down to that level until the December statement. A wrong forecast, acted on in good faith, produces exactly the outcome commentators point to: real rates that turn out, in hindsight, to have been too tight — or too loose.

Of course, the RBI knows this. As a result, it is extremely pragmatic. In exceptional periods, when the direction of inflation and growth is relatively more obvious, monetary policy can afford to be more aggressive. For example, when Covid hit, it was obvious that aggregate demand would collapse. So, the RBI was comfortable reducing the repo rate to very low levels. But outside such periods, the RBI has been cautious about reacting to new forecasts, keeping the repo rate in a narrow band of 5.25-7 percent, tighter than the range of inflation (2-6.8 percent). This makes sense. When monetary policy is partly forward-looking yet forecasts are error-prone, it is prudent to practise caution.

In summary, it is not correct to assert that the RBI has been biased toward tight monetary policy or that its rate-setting framework is flawed. The real task for the central bank is to improve its inflation forecasts. This is where the debate should move.

Forecasts will never be precise, because the future is always unknown, and it is also true that the global economic environment is unusually uncertain right now. Even so, there are many ways to reduce the size of the RBI's forecast errors.

To start with, India's macroeconomic data has well-documented weaknesses, often giving conflicting signals about how the economy is actually doing. Complicating matters further, whenever the statistical agency introduces a new series for GDP and inflation, it does not release much of a back series, leaving the RBI without the historical data it needs to build accurate models of how the new data behave.

Then, there is the question of household inflation expectations. Existing surveys need better language, because it may not be easy to understand what "inflation rate" means. It is also important to collect data on inflation expectations of firms. Once this is done, deeper research is needed into how inflation expectations actually form and how they feed into long-term contracts. This will also require better data on wages and rents.

A central bank that sets monetary policy based on forecasts is only as credible as its forecasts. That is where the real work needs to go, not in reopening the case for or against the inflation targeting framework itself.

RBI's clarity of communication will be as critical as the policy itself

Business Standard March 17, 2026

The Reserve Bank of India will announce its next monetary policy on April 9. While every meeting of the Monetary Policy Committee (MPC) draws close scrutiny, this one comes at a particularly critical juncture because of the conflict in West Asia. Even if the MPC leaves the policy rate unchanged, its communication will be crucial in calming financial markets amid heightened uncertainty. Markets will look for clear guidance on how the MPC interprets the uncertainty and what it implies for the future course of monetary policy.

In inflation-targeting economies such as India, communication is a key instrument of monetary policy. Financial markets analyse MPC statements and the governor’s remarks for signals about the future path of interest rates. When central bank communication becomes complex or ambiguous, market volatility tends to rise (Sengupta and Mathur, 2019). This matters even more in periods of uncertainty, when investors and firms struggle to form clear expectations about the economic outlook.

Two main sources of uncertainty will shape the backdrop to the MPC’s decision in the coming weeks.

The first is the war in West Asia. Until recently, India’s macroeconomic conditions appeared stable, with strong growth and moderate inflation. That stability has quickly eroded.

The conflict has disrupted supplies of key commodities such as crude oil, natural gas, and fertilisers. India imports nearly 90 per cent of its crude oil, about half of its natural gas, and roughly a quarter to a third of its fertiliser needs, much of it from West Asia. Prolonged disruptions could push up domestic energy and fertiliser prices and eventually feed into food prices and headline inflation.

Inflation had already begun to edge up even before these shocks. The consumer price index-based inflation rose to 3.2 per cent in February, a nine-month high. Although still below the RBI’s 4 per cent target, the margin for comfort has narrowed compared with June 2025 to January 2026, when inflation averaged about 1.5 per cent.

At the same time, disruptions to global trade routes could hurt exports and production, given that West Asia accounts for roughly 15 per cent of India’s exports. Higher energy costs may further weaken output and growth. Supply shortages often force adjustments that compress demand. The government has asked domestic gas producers to divert supplies towards households, reducing availability for industries such as plastics, chemicals, fertilisers and aluminium. Restaurants and other service sectors that rely on gas may face higher costs and weaker sales. Rising jet fuel prices are also pushing up airfares, which could dampen travel and tourism demand.

This creates a policy dilemma for the MPC. Should it prioritise containing inflation and adopt a more hawkish stance, or support growth as uncertainty rises? The committee will also need to clarify whether the recent increase in inflationary pressures is likely to be temporary or could it generate second-round effects that require a policy response. Markets will look for clarity on how the MPC balances these risks, without which, uncertainty about the policy outlook will persist.

It is also worth noting that even though the RBI reduced the repo rate by a cumulative 125 basis points in 2025 to support growth, long-term bond yields have not fallen. The yield on the 10-year government security has risen to around 6.75-6.80 per cent, close to levels seen before the rate-cutting cycle began. Normally, bond yields decline when policy rates fall. This divergence reflects rising uncertainty in financial markets. A clear articulation of the MPC’s assessment of macroeconomic risks could help stabilise expectations and prevent further increases in yields during this volatile period.

The second source of uncertainty is the new CPI index introduced in February. The revision changes both the weightings assigned to items and the composition of the consumption basket, which has expanded from 299 to 358 items. The weight of food has fallen sharply from about 46 per cent to around 37 per cent. Within food, the share of volatile items such as cereals has declined, while relatively stable components such as protein-rich foods have gained importance. A lower food weight may make headline inflation less sensitive to temporary supply shocks, such as monsoon variability. If inflation becomes less volatile, monetary policy could also become more predictable.

But the implications are not automatic. Markets will want to understand how the MPC interprets the new index. Does the change in weightings alter its assessment of inflation dynamics? Will food shocks play a smaller role in policy decisions? Could the behaviour of core (non-food, non-fuel) inflation change? Clear communication on these questions will help stabilise expectations as the new CPI becomes the basis for monetary policy.

As the MPC prepares its April 9 statement, clarity of communication will matter as much as the policy decision itself. Minimising surprises and setting clear expectations will help ensure monetary policy remains effective in the volatile months ahead.

Monetary policy needs good data

Business Standard December 16, 2025

The Reserve Bank of India’s (RBI) policy rate cut on December 6 took many analysts by surprise. It came just after the government reported that the economy was growing at a staggering rate of 8.2 per cent. According to the standard macroeconomics playbook, when an economy is growing so fast, central banks are expected to tighten monetary policy — meaning they raise rates pre-emptively — to control inflationary pressures and stop the economy from growing too quickly.

This time, however, the situation was different because inflation has been running at less than one per cent. This comfortable price environment gave the RBI the flexibility to lower rates but it does not automatically justify such a move. The core dilemma remains: Why provide further stimulus to an economy that is already booming at an 8 per cent growth rate?

Does this mean the RBI’s policy decision was misguided? Not really. Rather, the rate cut becomes perfectly understandable when viewed through the lens of the policymakers’ primary dilemma: The need to guide the economy while navigating through a thick statistical fog.

Let us begin by examining the gross domestic product (GDP) data itself. Official figures suggest that growth is soaring, far above last year’s estimated growth rate of 6.5 per cent. On the surface, the expansion appears broad-based and robust, with the manufacturing and services sectors each growing at 9 per cent.

The problem, however, is that these numbers are hard to explain. Some commentators have suggested the cuts in goods and services tax (GST) rates boosted consumer spending, thus raising GDP. But this is unlikely: The tax cuts started on September 22, too late in the July-September quarter to significantly affect the data.  Could other key indicators help provide a clue? Not really. In fact, they raise further questions. 

This sets off a virtuous cycle. Credibility keeps expectations anchored, stable expectations help keep prices low, and low inflation in turn strengthens credibility.

For example, industrial output grew by only 3 per cent during April-September 2025. This is the slowest growth since the pandemic year of 2020-21. The core sectors of mining, manufacturing, and electricity showed slower growth or even contracted. 

Bank credit growth also suggests a weakening economy, with non-food credit — a proxy for credit demand, slowing to 10 per cent in the July-September period from a growth rate of 13 per cent in the previous year. 

Perhaps most worrisome, tax collections have decelerated dramatically. During April-September, the central government’s gross tax collections grew by only 2.8 per cent, the slowest pace in 15 years. Income, corporation tax, and GST all grew in low single digits. 

Finally, it is hard to square strong growth with the weak rupee. The Indian rupee has depreciated by more than 6 per cent against the US dollar this year, making it the worst-performing currency in Asia. While external factors have hurt exports, the current account deficit remains modest at less than 2 per cent of GDP and should, therefore, be easy to fund. But this has not proved possible, thereby putting pressure on the rupee. Capital inflows have remained feeble, and oddly enough, have weakened further after the GDP news was announced. The inability of the fastest-growing country in the world to attract capital seems quite an anomaly. 

In short, it is hard to know how the economy is truly performing. What does this mean for policymaking? 

For the RBI, it makes its job very difficult. To target inflation effectively, the RBI must set interest rates based on its inflation outlook. But if it cannot reliably assess the real strength of the economy, how can it accurately forecast future inflation?

It is true that all central banks find it hard to forecast inflation because food and fuel prices are volatile. They usually fix this by basing their forecast on core inflation, which leaves out these volatile items. However, the situation becomes harder for the RBI when it cannot even forecast core inflation, because it cannot properly judge the underlying strength of the economy.

In such circumstances, policymakers have to adopt an approach based on managing risks. The RBI likely worried that collapsing inflation was causing real interest rates to rise. This, in turn, could severely harm the economy if demand was actually weak. On the other hand, cutting the nominal interest rate would not threaten the 4 per cent inflation target, even if demand turned out to be strong, simply because inflation is so low right now. Therefore, the RBI cut rates. For the same risk-based reason, the government also reduced GST rates.

Both policy decisions were reasonable, but a large problem remains: They may prove wrong if it turns out that demand is, in fact, quite strong. Meanwhile, the inability to come up with accurate macroeconomic forecasts has already confused financial markets. This confusion has potentially weakened policy credibility, creating further problems.

For all these reasons, it is imperative to resolve the data issues. The good news is that the National Statistical Office will soon release updated GDP and consumer price index (CPI) series. We can only hope that these new numbers will mark a significant improvement. Until they do, monetary policy will remain constrained by this data uncertainty.

The good run of inflation targeting: Keep the framework, improve data

Business Standard November 19, 2025 (with Vaishali Garga)

(The authors are, respectively, with the Indira Gandhi Institute of Development Research and Federal Reserve Bank of Boston. The views expressed in this article are solely those of the authors and should not be reported as representing the views of the Federal Reserve Bank of Boston, the principals of the Board of Governors, or the Federal Reserve System.)

Next year a critical policy review looms for the Indian government: Whether to retain or revise the inflation-targeting framework, a cornerstone of India’s monetary policy for a decade. Critics have been pushing for major changes — ranging from tweaking the target number to redefining the target variable, or even shifting the Reserve Bank of India’s (RBI’s) core mandate. However, a major revision now would be unwise because evidence shows that the framework has delivered.

India's formal adoption of inflation targeting in 2016 marked a fundamental shift in the way monetary policy was conducted. Until then, the RBI had been juggling several goals — rapid economic growth, adequate credit flow, and a stable exchange rate. This left its primary responsibility of controlling inflation somewhat diffused. The 2016 reform fixed that by giving the RBI a single, clear mandate: Keep the inflation rate based on the consumer price index (CPI) at 4 per cent, give or take 2 percentage points. This framework made the central bank’s objective both clearer and easier to evaluate.

That said, lower inflation by itself does not prove that the framework has succeeded. Prices can fall for reasons that have nothing to do with monetary policy — like a global drop in commodity prices or strong agricultural output. In fact, studies show that such favourable shocks played a big role in bringing the inflation rate down soon after the framework was introduced. Critics point to this and argue that the success in this respect was driven more by good luck than by sound policy.

But this argument overlooks the real test, which came later. Between 2022 and 2024, global energy and food prices spiked after war in Ukraine started. In India, the food inflation rate averaged about 7 per cent. Yet, barring a few months, the overall inflation rate stayed within the target band for most of this period. This was a sharp contrast to the pre-framework years, when similar shocks routinely pushed the inflation rate into double digits. This stability suggests that something deeper than good luck is at work: The RBI has built credibility.

Credibility is at the heart of any inflation-targeting regime. It captures the public’s confidence that the central bank will follow through on its commitment to keep prices in check. When households and firms trust the RBI, temporary supply shocks, such as spikes in food or fuel prices, do not immediately feed into long-term inflation expectations. In other words, expectations stay anchored. And once expectations are anchored, inflation itself becomes easier to manage because firms are less likely to raise other prices in response to a shock, and workers are less likely to demand higher wages.

This sets off a virtuous cycle. Credibility keeps expectations anchored, stable expectations help keep prices low, and low inflation in turn strengthens credibility.

There are signs that this cycle is beginning to take hold in India. Surveys show that while people still expect the inflation rate to be higher than the 4 per cent target, their expectations fluctuate far less than they once did. Research by RBI economists Sitikantha Pattnaik, G V Nadhanael, and Silu Muduli (2023) finds that households’ inflation expectations have become less sensitive to short-term price movements — another indication that expectations are gradually becoming more anchored.

Studies of professional forecasters show the same pattern. Research by Bhanu Pratap and Kundan Kishor (2023) and by IMF (International Monetary Fund) economists Patrick Blagrave and Weicheng Lian (2020) finds that medium-term inflation forecasts have become more stable and less sensitive to short-term inflation surprises. In our own research (Vaishali Garga, Aeimit Lakdawal Lakdawala and Rajeswari Sengupta, 2022), we find that professional forecasters now expect the RBI to react more strongly to rising inflation than it did before the inflation-targeting regime. Their expectations have also become less responsive to shocks in oil prices. Together, this evidence suggests that India's recent inflation stability is not just the result of favourable global factors. It reflects a steady buildup of policy credibility.

In this context, making major changes to the framework would be risky because it could undermine the credibility that has been built since 2016. This does not mean the framework cannot be improved. Rather, any changes should focus on better data, greater transparency, and clearer communication — not on rewriting the core rules. Two areas for improvement stand out.

First, the RBI's survey of household inflation expectations needs a major upgrade. At present, it asks people mainly about expected price changes over the next three months or one year. The survey should be redesigned to capture households’ longer-term inflation expectations more effectively. This would offer far more useful insights for policy because decisions about saving, investing, or negotiating salaries depend on how people expect inflation to evolve over several years — not just in the near term.

Second, policymakers need better information on what businesses expect. Since firms are the ones that set prices and wages, their view of future inflation is crucial. Yet India currently lacks systematic data on firms’ inflation expectations. The RBI could address this gap by regularly surveying firms and publishing the results. This would help the central bank judge whether price pressures are becoming entrenched and enable it to respond more effectively.

The next decade will bring fresh challenges — climate-related supply shocks, volatile energy prices, and global financial uncertainties. The best way for India to prepare is by preserving and strengthening the RBI’s hard-won credibility. If, instead, the framework is rewritten and trust in monetary policy is weakened, rebuilding that credibility could take another decade or more.

Reinforcing the Anchor: The Next Five Years of Inflation Targeting in India

Reinforcing the Anchor: The Next Five Years of Inflation Targeting in India, Leap Blog, Sep 25, 2025

Inflation vs Exchange Rate: RBI’s conflicting objectives

Business Standard February 18, 2025

Since November 2024, the Reserve Bank of India (RBI) has allowed the rupee to weaken against the US dollar, ending the effective peg that it had maintained for nearly two years. However, it has continued to intervene in the foreign exchange (FX) market to limit the rupee’s decline, keeping it the least volatile major currency in Emerging Asia with a modest 3 percent depreciation. This has, however, strained monetary policy and tightened liquidity at a time when the economy is weak and needs support.

To understand how this has happened, we must examine the link between monetary policy, currency management, and liquidity. The rupee weakens (or the dollar strengthens) when dollar supply in the FX market falls short of demand, such as when India's diminishing growth prospects discourage capital inflows. To counter this, the RBI can sell dollars from its FX reserves, preventing or even limiting rupee depreciation. However, it does not give dollars for free; it sells them for rupees. This absorbs rupees from the system, thereby tightening monetary conditions.

The RBI conducts this transaction with banks. When a person asks a bank to exchange Rs 1 lakh for dollars, the bank typically goes to the FX market, finds a seller, and matches the buyer with the seller. In this case, the bank acts as an intermediary, profiting from the spread between the buying and selling rates.

However, when a bank gets dollars from the RBI, the process changes. The bank must provide Rs 1 lakh to pay for the dollars, but its assets mostly consist of loans and government securities. Only a small portion of bank deposits is held at the central bank due to the CRR (cash reserve ratio) mandate. This is what the bank uses to pay the RBI when the latter sells dollars. This means when banks buy dollars from the RBI on a large scale, their balance at the RBI can fall short of requirements, causing their liquidity to tighten.

This is exactly what has been happening. For most of the past few years, the banking system had a healthy liquidity surplus. However, over the past few months, the RBI has sold large amounts of dollars, causing its FX reserves to drop sharply from USD 704 billion in September 2024 to USD 630 billion in January 2025. As a result, domestic banking system liquidity has shrunk, and the system is now in a large deficit, around Rs 1-2 lakh crores.

To address this, the RBI has taken two approaches. On a daily basis, it has been lending funds to the banks. It has also repeatedly engaged in open market purchase operations, buying government securities from banks to replenish their deposits at the RBI. These actions have ensured that banks have the necessary funds to conduct their business. However, this does not mean the RBI’s FX intervention has been without consequences.

This is evident in the graph below, which shows the difference between the weighted average call rate (WACR) and the RBI’s policy repo rate. The WACR reflects banks' borrowing costs in the overnight interbank market. When banks have a liquidity surplus, the WACR goes below the repo rate, resulting in a negative spread. However, as liquidity has tightened, particularly since November 2024, the spread has become positive, indicating that banks facing a cash shortfall have struggled to secure the necessary funds.

Figure 1: Spread between weighted average call rate (WACR) and repo rate (Source: RBI)

This matters because the RBI has now signalled its intention to ease monetary conditions. On February 7, the central bank lowered the repo rate, citing weaker inflationary pressures and slowing growth. However, just days after the cut, the RBI conducted a massive FX intervention to prevent the rupee’s depreciation. Though FX intervention data is released with a lag, anecdotal evidence suggests the RBI sold between USD 7 to 11 billion in only two days. This action tightened monetary conditions and raised the WACR.

In effect, the central bank has been sending mixed signals. Is the RBI truly committed to ease monetary conditions – or not? It is difficult to decipher from its actions.

For banks, the message is clear: as long as the RBI keeps liquidity tight and interbank lending conditions remain strained, they will be hesitant to lower their own interest rates. This reluctance means the RBI's repo rate cut will not get transmitted to the rest of the economy, and the monetary stimulus will fail to materialize. In short, the RBI's exchange rate management strategy is undermining the effectiveness of its monetary policy.

The law mandates that the RBI's primary objective is maintaining price stability, keeping an eye on growth. It does not mention managing the exchange rate. It is time for the central bank to focus on managing inflation and growth, allowing the exchange rate to adjust based on fundamental factors.

Why going back on inflation targeting could erode credibility of RBI

Indian Express September 24, 2024

Should India modify its inflation targeting (IT) framework, or even abandon it completely? Several commentators have raised this question recently, ahead of an official review of the monetary policy framework due in March 2025. Without doubt, periodic policy reviews are important – that’s why they are mandated in the IT law. And it’s also true that policies can always be improved. But the big picture needs to be kept in mind, which in this case is that IT has succeeded beyond expectations, making it one of the most important reforms of the last decade. Going back on this reform or making substantial changes to "loosen" the framework would erode the credibility of the central bank, damage the economy, and backfire in a political sense. Let’s consider how.

Before going into the debate, it is important to recognise what the upcoming review entails. According to the amended RBI Act, "the Central Government shall, in consultation with the Reserve Bank of India, determine the inflation target in terms of the Consumer Price Index, once in every five years". Strictly speaking, this refers to the numerical target of 4 percent with a band of plus or minus 2 percentage points on either side. However, this instruction can also be interpreted more broadly. Hence, the debate triggered by the Chief Economic Advisor needs be taken seriously. If some of the changes proposed are adopted – in particular, the suggestion that the RBI target only a subset of the CPI, excluding food prices--they would soon have enormous impact on the public.

Three points are worth noting in the context of this debate.

First, it is important to remember why IT was implemented in the first place. During 2009-2012, the UPA-2 government let inflation go out of control. CPI inflation reached 15 percent in March 2010, the highest among all the major G20 countries. And yet no one was held responsible, because the RBI was following a “multiple objectives” approach, under which it wasn’t firmly committed to any particular target. The resulting public outcry was so strong that the UPA was voted out of office (for this and other reasons) and a new government voted in, which pledged it would not allow such an episode to occur on its watch. To make this promise concrete, it enshrined IT into law.

Second, the reform has proved successful, far more so than many people anticipated at the time IT was adopted. The RBI has generally kept inflation within the 4-6 percent band; even when inflation has breached the upper limit, the deviations have been modest. Notably, inflation has never gone back to double digits, despite the serious food, oil, and pandemic shocks of the last few years.

Third, this success has brought benefits, both economic and political. Price stability has helped fuel growth, because it has allowed businesses to plan without worrying too much that their projections will be upset by surging costs. It has also reduced interest rates because it has improved central bank credibility, meaning that the RBI no longer needs to raise interest rates by as much as it did in the 2010s to convince people that it is serious about tackling inflation. Recent research conducted by Vaishali Garga, Aeimit Lakdawala and myself shows that market participants view RBI’s commitment to IT as credible. And price stability has paid political dividends, or at least allowed the NDA to avoid the political costs of high inflation suffered by the UPA.

But what about the argument that the RBI should narrow its target, to exclude food prices which it cannot control? The problem is this is a theoretical argument. And in the end, the theoretical points are not relevant. After all, the purpose of a government is to provide services that the public needs and desires. And the Indian public has made it clear that it desires price stability. Not for a subset but for its entire consumption basket, especially including food. Put another way, there’s a reason why all major central banks target inflation. And there’s a reason why they all include food in their target indices. Because it is what the public wants, indeed demands.

That said, there are indeed theoretical factors that the RBI cannot ignore. Central banks worry about rising food prices because of what is referred to as “second-round effects” such as the spillover of food inflation to non-food inflation through a wage-price spiral. Workers faced with higher food prices, demand higher wages in order to compensate for their rising cost of living and this in turn pushes inflation up even more. Some commentators have argued this consideration does not apply in India, noting that recent food price increases have not had any spillover. That may be true, but again is irrelevant, as it confuses the particular for the general.

In recent months in India, declining core (non-food, non-fuel) inflation implies that the second round effect is weaker right now. This is because there is pervasive unemployment in the economy. When there is surplus labour or a lack of adequate jobs, as is the case now in India, the workers are not in a good position to demand. They have less bargaining power to demand higher wages when food prices go up. In such a situation the wage-price spiral may not get triggered and hence we are not seeing steep increases in non-food inflation. But in the mid 2000s when the economy was booming and the labour market was tight, high food prices set off a wage-price spiral. This situation could easily recur if the economy grows rapidly over the medium-term, in which case changing the framework to tell the RBI to ignore signals from rising food prices could prove disastrous.

What is instead required is for the RBI to strengthen its analytical framework, given that its inflation and growth forecasts have frequently been subject to large errors. This in turn requires improving the underlying data, especially the CPI and GDP, which are outdated and have methodological issues. And it also requires a better understanding of agriculture, to assess whether food inflation is temporary or a reflection of some deeper, structural issues.

Implementing reforms in a messy democracy like India requires years of work and discussion. Even after a decade, the IT framework is still in its nascent stages and is being put to test by various shocks. It’s important to let it mature, making incremental rather than major changes that would endanger the overarching goal of price stability. As they say: if it isn’t broken, don’t fix it.

Inflation is under control. What’s next?

Indian Express February 20, 2024

Recently released data reaffirms that inflation in India is much less of a problem now than it was a year ago, in part, thanks to the monetary policy stance of the RBI. But what is the right policy going forward? The answer is not obvious — perhaps not even to the RBI.

Over the past three years, India experienced high and persistent inflation. Between April 2021 and September 2022, the wholesale price index (WPI) inflation averaged 13 per cent, the highest in more than a decade, triggered by the pandemic disruptions and the Russia-Ukraine war. Surges in wholesale prices normally suggest “inflation in the pipeline” and indeed, they soon translated into high retail inflation. During the first three calendar quarters of 2022, consumer price index (CPI) inflation averaged 7 per cent. Even excluding the rise in food and fuel prices, core inflation still hovered above 6 per cent for nearly every month from May 2021 to March 2023.

The persistence of core price pressures implied that high inflation had become embedded in the system. It seemed as if inflation had become the Achilles heel of the Indian economy’s recovery from the pandemic. Since then, the inflation dynamic seems to have changed. Starting April 2023, wholesale price inflation turned negative. According to the latest data, headline CPI inflation fell to 5.1 per cent in January 2024, the lowest in three months. With this, inflation has now been within the RBI’s tolerance band of 2 to 6 per cent for five consecutive months. Even more striking, core inflation came down to only 3.6 per cent in January, its lowest rate since the start of the pandemic. While there is still some way to go before the target of 4 per cent can be achieved on a sustained basis, it now seems much closer than it did two years ago.

This remarkable achievement can clearly be attributed to two factors: RBI’s dogged pursuit of a tight monetary policy and the softening of commodity prices.

However, going forward, the conduct of monetary policy might get complicated owing to a set of puzzles. To understand this, we need to consider how monetary policy gets transmitted to the wider economy. Let’s revisit the basics.

When the RBI pursues contractionary monetary policy, it gets transmitted to the rest of the economy through financial intermediaries such as the banking sector. In response to the RBI’s hikes in the policy repo rate, banks promptly raise their lending rates and eventually, their deposit rates. The rise in the bank lending rate increases the cost of borrowing. As households and businesses borrow less, they also spend less which in turn weakens demand. Additionally, as deposit rates go up, households find it more attractive to deposit their savings in the banks, rather than spending it in the shops. As a result, both consumption and investment start slowing. And as aggregate demand starts falling, prices start coming down, assuming that there are no disruptions on the supply side. In other words, monetary tightening operates by weakening demand, thereby slowing down both GDP growth and inflation.

For this reason, a standard way for economists to assess the success of monetary policy is by looking at core inflation. If core (that is, underlying) inflation is close to the target, it suggests that monetary policy is doing its job of controlling demand, notwithstanding any temporary deviations caused by flare ups in food or commodity prices. For instance, in the US, after several quarters of aggressive monetary tightening, headline inflation has cooled down quite a bit. Annual inflation in the US fell to 3.1 per cent in January, compared to 6.4 per cent a year ago. However, core inflation continues to be sticky and has been rising more than expected. Also, wages in the services sector have been persistently high. Both these indicate that demand conditions remain strong, thereby causing the US Fed to delay rate cuts.

Now let’s turn to what’s been happening in India.

Between May 2022 and April 2023, the RBI raised the policy repo rate by 250 basis points. Since then, it has held the repo rate constant at 6.5 per cent. In response, the weighted average lending rate in the banking sector has gone up by less than 200 basis points while the average deposit rate has gone up by more than 200 basis points. Even though the transmission remains incomplete, the resultant decline in demand seems to have started softening prices. This is evident from the decline in core inflation in recent months and from the RBI’s latest forecast, which shows that CPI inflation will come down to 4.5 per cent in 2024-25, much closer to the target. So far, so good.

The story however gets confusing if we look at the RBI’s GDP growth forecast. The economy is expected to grow at 7 per cent in 2024-25 amidst a slowing global economy, implying that domestic demand will be quite strong. This raises a set of puzzling questions: If indeed monetary policy is slowing demand down and cooling off inflation, how can GDP growth continue to be high? Alternatively, if demand will somehow be strong next year, then why would inflation continue to fall?

The recent MPC statements are silent on this. In particular, they do not mention the lagged impact of tight monetary policy on the growth outlook. This seems like an important omission especially since the passthrough is not yet complete and will most likely continue to work through the system over the next few months, thereby further dampening demand.

Given that the legal mandate of the inflation targeting framework is``price stability with an eye on growth", these puzzles need to be resolved before the RBI can figure out the appropriate stance of monetary policy.

Consider the following: If indeed the economy is expected to perform well in 2024-25, there is no imminent need for a rate cut. We may even see a resurgence of inflation, given that demand conditions are predicted to remain strong. If, however, the underlying demand conditions are weakening, then a rate cut may be needed sooner. After all, the last thing a slowing economy needs is a tight monetary policy. It will be interesting to see how monetary policy responds to this conundrum.

Is the good run of the Indian banking sector over?

Is the good run of the Indian banking sector over?, MoneyControl, June 6, 2023.

Is the RBI’s commitment to inflation targeting credible?

Is the RBI’s commitment to inflation targeting credible?, Ideas for India, May 24, 2023.

Don’t hit pause in the battle to contain inflation

Hindustan Times April 8, 2023

On April 6, the Reserve Bank of India (RBI) announced its first monetary policy decision of the financial year 2023-24. Going against widespread market expectations, it decided to hold the repo rate at 6.5%, pausing the rate hike cycle that began in May 2022. Unfortunately, the Monetary Policy Committee (MPC) statement does not fully explain why. All we can, therefore, do is speculate about the possible reasons behind this pause and discuss what MPC may need to do going forward.

Let's start by understanding what has changed since the last MPC meeting of February 8. There have been three main developments.

First, inflation pressures have arguably increased. Back in February, when MPC raised the repo (or policy) rate by 25 basis points, the latest data (for December 2022) showed that headline inflation had moderated to 5.7%, whereas going into the latest meeting headline, consumer price index (CPI) inflation had gone up to 6.4% in February 2023. In the run-up to both meetings, core inflation (non-food, non-fuel) remained elevated above 6%, the upper-limit of RBI’s tolerance band.

Second, the global economic environment has become significantly more uncertain compared to February, because of the turmoil in the financial markets in the US and European Union. With the collapse of a few mid-sized banks in the US and the forced take-over of the systemically important Credit Suisse by UBS, financial stability concerns resurfaced, which in turn, complicated the tasks of central bankers.

Third, the rupee-to-dollar exchange rate stabilised in recent weeks, after depreciating chronically in 2022, largely because markets now expect the US Federal Reserve to be less aggressive. The Fed has been tightening monetary policy since the start of 2022, increasing its policy rate from essentially zero to 5%, to rein in inflation which shot up to 9%, the highest in four decades. Arguably, this aggressive tightening triggered the financial instability in the US. The ensuing chaos prompted analysts to expect that the Fed will now slow down the pace of rate hikes in order to balance financial stability concerns with inflation control.

Which of these factors can help explain MPC's latest pause?

Clearly, it was not the first factor, given that inflation is still far from under control. RBI is legally mandated to bring headline CPI inflation down to 4%. Its inflation forecast for 2023-24 is 5.2%, implying that the central bank expects that inflation will remain well above target for the second consecutive year. What is more worrisome is that underlying (core) inflation is likely to be even higher, persistently hovering around 6% for several years now. The MPC statement recognises these problems, stressing the “importance of low and stable prices” and “not letting the guard down on price stability”, while pointing out that work needs to be done to “[anchor] inflation expectations” and “rein in generalisation of price pressures”. Yet, despite such a hawkish assessment, it did not vote in favour of a rate hike.

Why not? One possibility could be that the previous repo rate increases have not been fully passed on by banks to their lending and borrowing rates. So the central bank might have decided that the priority should now shift to ensuring that monetary transmission improves, either by tightening bank liquidity or exhorting banks to raise their rates. But there was no sign of any such initiative in the MPC statement.

So maybe the second factor, global uncertainty, played a key role? Perhaps RBI was worried that problems abroad could weigh on India’s growth? Apparently not. The central bank actually increased its 2023-24 GDP growth forecast, albeit marginally, to 6.5%, indicating that growth worries were likely not the major factor driving its decision.

Perhaps, then, exchange rate factors played the key role. It is certainly striking that RBI’s actions over the past year seem to have been mirroring those of the Fed. When the Fed was aggressively raising rates during 2022, RBI kept increasing its repo rate. And when the Fed decided in 2023 to slow down the pace of rate hikes, RBI responded by pausing. Hence, it is possible that there is some link between US and Indian monetary policy, perhaps motivated by a desire to protect the exchange rate by ensuring that rupee interest rates remain significantly higher than those in the US.

If indeed the pause was driven more by exchange rate factors than by domestic inflation – though RBI governor Shaktikanta Das said that monetary policy was driven by domestic factors, not international – then it needs some reflection. External considerations should not distract RBI from its primary objective of restoring price stability in the domestic economy. Traditionally, ensuring that the exchange rate remained stable against the US dollar could aid in this task, as US inflation used to be low. But times have changed. As long as inflation in developed economies remains elevated, India runs the risk of importing this high inflation.

Consequently, achieving the inflation target will require RBI to focus on exerting downward pressure on domestic inflation, especially now that high core inflation has become entrenched in the system. In particular, MPC needs to ensure that the real interest rate (the difference between the repo rate and core inflation) is firmly in positive territory if there is to be any chance of breaking the persistence of core inflation. Currently, the real rate is barely there.

Persistently high inflation hurts the poor the most. Volatile inflation can be inimical to growth, a troubling possibility given that India’s medium-term growth prospects look uncertain. Therefore, inflation control remains crucial to India’s future. Unfortunately the monetary policy decision did not throw much light on RBI’s plan to bring inflation down.

Should monetary policy be used to target financial stability?

Mint, April 2, 2023 (with Harsh Vardhan)

The recent financial market turmoil in the US triggered by the collapse of the Silicon Valley Bank has raised questions about the impact of the US Fed’s monetary policy on the stability of the banking system. More generally it has brought back to fore a fundamental question that central banks all over the world have been grappling with for a while now – should financial stability be given priority over inflation in the conduct of monetary policy? There is no easy answer to this as both problems are serious.

This issue is of crucial importance for India as well. It has been less than a decade since the Reserve Bank of India adopted inflation targeting as its monetary policy framework and under IT, the primary goal of monetary policy is achieving price stability. Expecting monetary policy to also keep an eye on financial stability, will distract attention from the central bank’s legally mandated objective, and may lead to destabilising outcomes for the economy in general.

There are some practical as well as conceptual problems in making financial stability an objective of monetary policy.

First of all, it is difficult to define financial stability. We can only see financial sector instability when it manifests for example through the failure of a systemically important bank, or the bursting of an asset price bubble, but before such an event occurs, we cannot precisely describe what is financial sector stability. Moreover, there are various institutions in the financial system involving a large number of participants that interact with each other thereby creating a complex, interconnected network. Within this system, sources of financial instability can be varied. We have seen financial instability occurring due to failures of banks, insurance companies, pension funds or mutual funds, and we have seen crises in the stock market and bond market. Ex-ante, it is often difficult to identify the specific part of this vast, complex network where a risk is building up.

Also, once instability occurs in any part of this network, given the interconnectedness, it can spread through the entire system leading to what is commonly known as contagion. It is difficult to predict whether an event of financial instability will indeed trigger a contagion, how rapidly the contagion will spread through the system or what impact it will have on different parts of the network.

Secondly, given that financial stability is difficult to define, it is also hard to measure. Often financial sector regulators use "stress tests" to assess the resilience of the system under various scenarios. Problem is that they only test for risks that they are worried about. There are many other risks beyond the obvious ones and typically those are the ones that get financial institutions into trouble, all the more making financial stability difficult to measure.

Monetary policy works best when it has clearly defined objectives and quantitative targets that guide its formulation. Given the challenges of defining and measuring, it is difficult for monetary policy to target financial stability as compared to price stability which can be both defined as well as measured. In India, for example, the IT framework clearly lays out the goal of the RBI’s monetary policy as achieving a 4% CPI (consumer price index) target. Such a clear, quantitative target is inconceivable when it comes to financial stability.

Finally, and most importantly, policymaking must be guided by the Tinbergen principle which conceives of economic policy as the relation between instruments and goals. It stipulates that the number of achievable goals is limited by the number of available policy instruments. Under the inflation targeting framework, the repo rate in India (or the Fed funds rate in the US) must be used to target inflation. It is therefore best to find another tool to address financial stability so that the Tinbergen principle can be applied.

So if monetary policy is not the answer, then what can be done to address financial instability?

Some have argued that central banks can inject liquidity to safeguard financial instability. There are three problems with this. First, injecting liquidity only makes sense when the underlying problem is illiquidity, say an irrational run against a bank with safe but illiquid assets (such as a loan to a profitable factory). But this is hardly ever the case. Usually, as in the case of SVB, runs occur because banks are insolvent i.e. the value of their assets has fallen below the value of their liabilities. In such a situation, the only solution is to inject capital. Injecting liquidity can in fact make matters worse because it enables more people to flee the ailing bank(s), thereby increasing -- not reducing – panic.

Secondly, liquidity can be a temporary solution in situations involving a credit freeze and, it may help restore confidence in the system. But it is like calling the fire brigade in the event of a fire; it is needed to douse the fire but does not help prevent future fires.

Third, addressing instability using liquidity may also mean keeping the system flooded with excess liquidity for a long time which in turn may endanger price stability.

Broad based financial stability can be achieved only by improving governance standards, and establishing strong supervisory oversight over the concerned institutions to help avoid the build-up of risks. The SVB collapse, like the Global Financial Crisis of 2008, reflected a colossal failure of governance and supervision.

In summary, in the short run, the solution to financial instability is capital; in the long run, it is better governance and supervision. Monetary policy would then be free to pursue its "natural target": price stability.

In the case of India on the other hand, price stability is a pressing concern. CPI inflation has been higher than the RBI's target level of 4% for a while now and in particular, core inflation has been remarkably stubborn at 6% for a long period of time. Hence, as the RBI gears up to announce its monetary policy decision on April 6, it needs to retain its focus on lowering the CPI inflation to the target level. The US Fed may have slowed down the pace of rate hikes in view of the latest financial market turmoil but that should not distract the RBI from prioritising domestic macroeconomic stability and inflation control.

The price pinch

Indian Express, February 16, 2023

Inflation is proving to be the Achilles Heel in the Indian economy’s recovery from the pandemic and subsequent global disruptions. After softening for three consecutive months, it spiked again in January. The Reserve Bank of India has been playing the part of an inflation targeting central bank over the last few months, raising interest rates in an attempt to rein in inflation. However the fight to bring inflation down is clearly far from over. The latest inflation data also raises the question if the RBI doing enough.

The inflation targeting framework mandates the RBI to achieve a CPI (consumer price index) inflation target of 4 percent. During the pandemic period of March 2020 to September 2021, CPI inflation averaged 5.9 percent. This was higher than the point target of 4 percent but still within the inflation targeting band of 2-6 percent. Since then, however, the inflation outlook has been worsening.

In 2022, CPI inflation was above the upper threshold of the RBI’s targeting band for 10 consecutive months which meant that the target was not achieved for three quarters in a row. Inflation began softening towards the later part of the year. By December 2022, CPI inflation was down to 5.7 percent. This led many to believe that the inflation peak had passed, and that inflation was on its way to the official target.

This optimism was misplaced. Underlying inflationary pressures still persist. The softening of inflation in November and December 2022 was largely driven by a steep fall in vegetable prices. Excluding vegetables, CPI inflation was infact more than 7 percent. The misplaced optimism has now become evident. The January 2023 CPI inflation came out to be 6.5 percent, once again crossing the upper threshold of the RBI’s inflation targeting band.

The risks to inflation outlook that have continued unabated over the last few months have contributed to the latest spike in inflation as well.

First, with food accounting for 46 percent of the overall CPI basket, a rise in food inflation from roughly 4 percent in December 2022 to almost 6 percent in January 2023 has played an important role in overall inflation going up. Within food, one component that has proved rather stubborn is cereal inflation. Between May and December 2022, year on year cereal inflation nearly doubled from 5 percent to 14 percent. In January 2023, this increased to 16 percent. Within cereals, inflation in wheat has been steadily going up. Between May and December 2022, wheat inflation increased from 9 percent to 22 percent. It increased even further to 25 percent in January 2023.

The steep rise in wheat prices reflects shortages. Data from the Food Corporation of India shows that stocks in government warehouses declined from 33 million tonnes in January 2022 to 17 million tonnes in January 2023. The government has recently approved a release of 3 million tonnes in the open market. However this is insufficient to restore market supplies. Given that the next harvest will not be ready till April, and government stocks in February are further down to 15 million tonnes, this source of inflationary pressure is likely to persist for a while.

Secondly, core (non-food, non-fuel) inflation in January came out to be 6.2 percent. This is consistent with the unyielding core inflation of 6 percent for nearly three years now. A persistently high core inflation implies that price pressures have become entrenched in the system. Part of this can be explained by the continued pass-through of high input prices to final goods prices. Interestingly this is happening even when WPI (wholesale price index) inflation, which reflects input prices, has come down from a high of 16 percent in May 2022 to less than 5 percent in January 2023. This implies that with margins getting squeezed and profitability suffering, firms are spreading out the pass-through over a longer time period. This makes the core inflation trajectory uncertain.

Finally, external factors have a role to play as well. Inflation in developed countries continues to be high (6.4 percent in US; 8.5 percent in EU; 10.5 percent in UK). India is importing some of this elevated inflation through international trade in goods and services. Moreover, with China gradually opening up its economy after nearly three years of Zero-Covid restrictions, commodity prices are likely to go up which could exert renewed pressures on India’s inflation.

What have the policymakers been doing to address the inflationary concerns?

The government has done its bit by announcing a conservative Union Budget for 2023-24. It has accorded primacy to much needed fiscal consolidation, and has refrained from announcing populist measures which could have arguably fuelled demand, and hence inflation.

The RBI has been doing its job as well. It increased the policy repo rate from a pandemic-low of 4 percent to 6.5 percent in a span of 10 months. It has also adopted a hawkish tone as was evident from its latest monetary policy statement. Unlike last year when despite rising inflation, the monetary policy statements did not contain any forward guidance, in its February 2023 statement, the RBI emphasised the importance to "remain alert on inflation", thereby hinting that the monetary tightening cycle is not over yet. Is there anything else that the central bank can do?

Having missed the inflation target for three consecutive quarters in 2022, the RBI had to submit a report to the government describing a plan of action which would help bring inflation down. The law does not require either the RBI or the government to disclose the contents of this report publicly. However, given that inflation is proving to be difficult to rein in, and that the 4 percent target is not likely to be achieved next year either, releasing the report to especially highlight the remedial actions that the RBI plans to undertake might help stabilise inflation expectations, and facilitate the central bank’s own endeavour to fight inflation.

A credible glide path to bring inflation down to the target level is of critical importance particularly now with the national elections around the corner.

RBI needs to remain vigilant on inflation

Hindustan Times, February 6, 2023

Now that the Finance Minister has presented the Union Budget which is neither populist nor expansionary, all eyes will be on the Reserve Bank of India as it gets ready to announce the monetary policy on February 8. Inflation in India seems to be on a downward trajectory from the high levels it had reached in the first half of 2022. Yet the RBI must be cautious about taking its foot off the pedal as far as taming inflation is concerned.

The RBI has been following an inflation targeting framework for conducting monetary policy since 2016. The framework mandates the RBI to achieve a CPI (consumer price index) inflation target of 4 percent. For the most part of calendar year 2022, CPI inflation averaged at 6.9 percent. The inflation target was not achieved for 10 consecutive months in 2022.

From October onwards inflation seems to have been declining. The average CPI inflation in November and December came down to 5.8 percent. This means that inflation is now back within the RBI’s tolerance band. This is a positive development not only because inflation seems to be moving towards the 4 percent target but also because high inflation disrupts macroeconomic stability.

However this recent decline should not be interpreted to mean that inflation has ceased to be a problem. There are four main reasons why risks to inflation persist.

First, while headline inflation has come down, core inflation (non-food, non-fuel) has been quite stubborn. In December 2022, core inflation was 6.2 percent, same as the full-year average. Infact core inflation has been sticky around 6 percent for almost three years now—from April 2020 to December 2022. Persistent core inflation implies that price pressures have become embedded in the system.

There may have been three phases that can help explain the core inflation dynamics. In the first phase, once the pandemic hit India, and widespread mobility restrictions were introduced, supply chain bottlenecks became intense, services were shut, goods and labour were hard to come by. This started putting upward pressure on core inflation. In the second phase, as the land war broke out in Europe in February 2022, input prices skyrocketed and manufacturing firms began passing on the higher costs to consumers. We can then think of a third phase, when commodity prices began easing thereby softening the input price pressures on the producers but services began actively normalising. For two years the services sector could not adjust wages and prices. Now that the economy has fully opened up, they are having to pay higher wages to workers to compensate them for the price increases that occurred while they were away, and are adjusting prices accordingly. This is keeping the core inflation high.

Apart from core inflation, cereal prices have been steadily going up. Between May and December 2022, cereal inflation more than doubled. Within cereals, inflation in wheat went up drastically from 9 percent in May to 22 percent in December, while inflation in rice increased from 3 percent to 10 percent during the same period. Food accounts for 46 percent of the overall CPI basket and within the broader food-group, non-perishables such as cereals, spices etc., have almost a 37 percent weight. This means that these items determine the underlying trend in CPI food inflation. Non-perishables inflation increased from 5 percent in November to more than 8 percent in December 2022, reaching the highest level in more than two years. In fact, much of the decline in overall CPI inflation both in November and December was driven by perishables such as vegetables which registered a steep fall in prices. Excluding vegetables, CPI inflation increased to 7.2 percent.

Third, while inflation in the developed world has also been coming down, it is still quite high. Inflation in the US was 6.5 percent in December, while inflation in the European Union as well as the UK remains more than 9 percent. Through the channel of international trade in goods and services, India continues to import this high inflation.

Finally, as China opens up after three years of Covid-related restrictions, recovery of its economy from a growth slump is likely to exert upward pressure on commodity prices, given that China accounts for a large share of global commodity demand. This may fuel inflationary pressures in India which imports commodities.

What should therefore be done by the policymakers?

The government seems to have done its bit. With nine state assembly elections scheduled between now and January 2024, and the country going into general elections in 2024, the apprehension was that the government would announce a slew of populist measures in the Union Budget presented on February 2nd. This would not only disrupt fiscal consolidation, it could also aggravate inflation. Strikingly enough, the government has not given in to populist demand pressures. It has announced a steep increase in capital expenditure which is undoubtedly a demand stimulus but a lot will depend on implementation.

Now the ball is in the RBI’s court. It needs to remain vigilant on inflation. While the central bank has been tightening monetary policy from May 2022 onwards increasing the repo rate to 6.25 percent, it now needs to clearly indicate when it expects inflation to reach the target level of 4 percent, and what its plan of action is to bring this about, particularly to break the persistence of the core inflation.

A low, and stable inflation generates macroeconomic stability and creates a favourable environment for growth. On the other hand, high, sustained inflation hurts the poorer sections of the society the most and can have a detrimental political effect in an election year.

Below 6% but 5 problems

Times of India, December 13, 2022

The latest data release for November 2022 shows that inflation is now within the RBI’s target range. This is undoubtedly good news. However, some major issues persist. Inflation remains much too high. And there is no clarity yet on how the central bank plans to bring it down to the target level.

Headline CPI (consumer price index) inflation came out to be 5.9 percent in November, down from 6.8 percent in October. This is the lowest inflation since December 2021. At the same time, global commodity prices have been falling, softening inflationary pressures. But that is pretty much where the good news ends. There remain at least five major concerns.

First, while it is true that inflation has slipped below the upper threshold of the RBI’s inflation targeting band, it is important to remember that 6 percent is not the RBI’s target. The RBI is legally mandated to aim for 4 percent inflation. This implies that there is still some way to go before CPI inflation reaches its target level.

Secondly, the decline in headline inflation did not reflect any fundamental change, but a steep fall in the price of vegetables. If one excludes vegetables, CPI inflation would infact have increased, to 7.2 percent.

Third, measures of underlying inflation indicate that price pressures remain stubbornly strong. Core (i.e., non-food, non-fuel) CPI inflation continues to be around 6 percent—the same level that it has been at for nearly three years now. This signifies that high inflation is deeply embedded in the system.

Why is core inflation so persistent, despite the easing of commodity price pressures? Most likely, because the economy is locked into a wage-price spiral. As the economy has opened up after two years of pandemic-induced restrictions, firms have had to pay higher wages to workers to bring them back, to compensate them for the price increases (for example, in fuel and transport prices) that occurred while they were away. Also, the depreciation of the rupee would have made it costlier for firms to import inputs. In both cases, firms seem to be passing these increases in costs on to the consumers in the form of higher prices.

Fourth, global inflation is still quite high. While inflation in the US has receded to 7.7 percent in October from 8.2 percent in September, inflation in the UK is 11 percent and rising, while that in the European Union has increased to 11.5 percent. As a result, India is importing high global inflation. This problem could intensify, if the rupee depreciates further, as advanced country central banks continue to tighten monetary conditions by raising interest rates.

Finally, cereal inflation remains exceptionally high, at 13 percent. It is difficult to understand why this is happening, since the government has been augmenting supplies by providing grains under its free food scheme (PM Garib Kalyan Anna Yojana) to all families holding a ration card. One possibility could be that traders are worried that the government’s buffer stocks are running low and that the winter harvest might prove disappointing.

Adding up all these factors makes it clear that it is way too early to declare victory on inflation. So, what is the strategy to bring inflation down?

It is true that the RBI has been consistently raising the policy repo rate since May 2022. The repo rate has gone up from 4 percent to 6.25 percent. The RBI has also been withdrawing surplus liquidity from the system to restrain the money supply. The Monetary Policy Committee (MPC) also seems more focused on inflation now compared to 2021-22. These are all steps in the right direction. But to break the persistence of the core inflation and bring inflation down to the target level of 4 percent, more effort might be required.

The RBI has predicted inflation to fall to 5.4 percent in the second quarter of 2023-24. But it has not yet indicated when it expects inflation to reach 4 percent—or what it plans to do to ensure that this target is achieved in a reasonable timeframe. Does it think that the current level of interest rate—which is only marginally higher than the underlying inflation rate—is sufficient to deliver the target in the next one year or so, implying that the RBI will continue to soften the pace of rate hikes or even end the tightening cycle soon? Or will further and steeper rate increases be necessary to ensure that monetary policy exerts sufficient downward pressure on inflation? It may help to provide some clarity on these issues.

Once the sanctity of a rule-based system is ignored for a while, it becomes more difficult to restore the credibility of that system. In India, a glaring example of this is the Fiscal Responsibility and Budget Management (FRBM) Act. After persistent deviations from the fiscal target for years, this institution has now ceased to be relevant and we may have normalised a high level of fiscal deficit. Inflation targeting should not suffer the same fate.

It is reassuring that the RBI has recently said that it has an “Arjuna’s eye” on inflation. It should now follow up by spelling out a strategy to ensure that Arjuna’s arrow hits its target.

On inflation, we are not out of the woods

Hindustan Times, December 5, 2022

The macroeconomic landscape in India seems to have suddenly changed. For most of this year, the main problem was surging prices, which had pushed consumer price index inflation far above the Reserve Bank of India’s target of 4 percent. In recent months however, inflation seems to have subsided. And now there is a new problem, as India’s export-led recovery is being threatened by weaking demand in the advanced countries, which seem to be slipping into recession. As a result of this shift in the landscape, some analysts have urged the central bank to shift its priorities, declaring victory over inflation, and focusing instead on the task of reviving growth.

At first blush, this shift seems reasonable. But we need to ask two questions. Is the inflation problem really over? And if not, what are the costs and benefits of shifting the policy stance?

Let’s understand the first question. It is true that inflationary pressures are softening. CPI inflation came out to be 6.8 percent in October, down from 7.4 percent in September. Alongside this, wholesale price index (WPI) inflation fell to 8.4 percent from an average of 14.9 percent in the previous nine months. It remains unclear though, whether these developments represent the start of a new trend or a temporary low. After all, core (i.e., non-food, non-fuel) CPI inflation has been running around 6 percent for the past three years, implying that inflation has become deeply ingrained at a level higher than the RBI’s target of 4 percent.

Moreover, there are still significant risks to the inflation outlook.

First, there has been a big spurt in the prices of cereals. Cereal inflation has gone up from 11.5 percent in September to 12.1 percent in October. In particular, the price of rice has gone up by 10 percent and that of wheat by more than 17 percent on a year-on-year basis. These developments are puzzling, considering that the government has been flooding the market, for some time, with cheap grains under both the PDS (Public Distribution System) and the PMGKAY (PM Garib Kalyan Anna Yojana) free food scheme that was launched in March 2020 as a Covid-relief measure. The latter scheme provides 5 kg of free foodgrains (wheat or rice) per person, per month for a family holding a ration card, and covers a significant portion of the population.

Why are cereal prices going up despite this massive free provision? One possibility could be that the government has used up much of the grains in its stock, and now the stocks are running low. If, on top of this, the winter wheat crop suffers, say due to the unseasonal October rains, then high cereal inflation could persist, thereby feeding a demand for higher wages, which would then translate into high general inflation.

Second, global inflation is still not under control. While inflation in the US has receded to 7.7 percent in October from 8.2 percent in September, inflation in the UK is 11 percent and rising, and that in the European Union has increased to 11.5 percent.

Third, the rupee may well remain under pressure in the coming months. As long as advanced country inflation remains high, their central banks will need to continue to raise interest rates from their historically low levels. Economists are currently expecting the US Federal Reserve to raise its policy rate by 100-150 basis points. The Organization of Economic Cooperation and Development (OECD) has recently indicated that rate hikes in the European Union would need to be even larger. These higher rates abroad will discourage capital inflows into India, which will be problematic for the rupee since India needs the inflows to fund its large and growing current account deficit.

For all these reasons, international and domestic, we can’t be sure yet that inflation in India is headed back to 4 percent. And this leads us to our next big question: should the RBI stay focussed on the inflation problem or should monetary policy instead focus on reviving growth? Consider the benefits and drawbacks of shifting its stance.

In principle, the main benefit of lowering interest rates is that it would encourage domestic investment. But it is far from clear that investment is being held back by high interest rates. In fact, private sector investment has been sluggish for the past decade, regardless of whether RBI policy has been tight or stimulative. As a result, it is difficult to believe that another shift in the RBI’s policy stance will make much of a difference.

Consider now the potential costs of such a shift. The most obvious cost is that stimulating the economy could worsen the inflation problem. However the biggest cost is perhaps much more subtle: when analysts urge the RBI to try to revive growth, they distract attention from the deeper policy actions that are required on the part of the government, namely the task of creating an economic framework that encourages firms to take risks and expand capacity. As a result, the reforms needed to revive investment are not undertaken.

In summary, we are still not out of the woods as far as inflation is concerned. Hence, we should let the central bank do its job, its legally mandated task of bringing inflation down to 4 percent. And we should encourage the government to focus on its mandate, of creating a supportive environment for investment and growth.

What the term premium is (or is not) telling us?

(with Harsh Vardhan) Bloomberg Quint, October 6, 2022

An important and usually reliable measure of the future economic outlook is the yield curve in the bond market. It is particularly useful when the overall economic environment is highly uncertain, such as now. The yield curve shows the yields of government securities (G-Secs) of various maturities. The steepness of the yield curve is often used as a proxy for market expectations about future interest rates, and hence future inflation and growth. In recent times however, the reliability of the yield curve and its information content have come into question.

One simple way to measure the steepness is the term premium. It is the difference between the yields at the short end and at the long end of the yield curve. In India, the long-term yield considered is typically the 10 year G-Sec yield while for the short-term, it is usually the yield on one-year treasury bills. Monetary policy has an important impact on the term premium. The actions of the central bank directly affect the short-term interest rate. The bond market interprets the central bank’s actions and statements and transacts long dated bonds setting the long-term rates.

Since May 2022, the RBI has been hiking the policy repo rate in response to the rise in CPI (consumer price index) inflation which averaged at 6.8% between January and August 2022. Accordingly the short-end of the yield curve has gone up from 5.1% in early May to 6.7% now. This is a move of around 160 basis points in the 1 year G-Sec yield.

The RBI has also been highlighting in its monetary policy statements the significant upside risks to inflation that remain a concern. It has specified that it will continue to withdraw surplus liquidity from the system which is consistent with a contractionary monetary policy. Its CPI inflation forecast for FY 2022-23 is 6.7%, much higher than its inflation target of 4%. This implies that monetary policy may need to be tightened in a calibrated manner for the next few quarters.

Moreover, monetary policy tightening in the US has led to a strengthening of the US dollar and accordingly an 11% depreciation in the rupee-dollar exchange rate in 2022 so far. This has been the fate of currencies across the world, not just in emerging economies, and has led to central banks raising interest rates in order to defend the exchange rates. There are talks among the analyst community in India that the RBI might follow suit. Given that the Fed has said it might increase interest rate by another 125 basis points by the end of 2022, any attempt to use monetary policy to defend the rupee’s value may require the RBI to raise rates significantly.

Given the circumstances, one might expect the yield curve to steepen i.e. long-term yields should go up alongside the short-term ones, reflecting market’s expectation of higher interest rates in the future.

What we see instead is that the rates at the long-end of the yield curve have gone up by only around 30 basis points – from 7.1% in early May to 7.4% now in comparison to the increase in the short end by about 160 bps. As a result, the term premium has come down to around 50-70 basis points from a long-term average of over 90 bps. This has led to a remarkable flattening of the yield curve which seems counterintuitive.

Such a flat yield curve implies that the bond market believes that the rate actions taken by the RBI would help control inflation, which in turn would lower the chances of future interest rate hikes. In other words, the market does not agree with the RBI as far as assessment of risks to inflation are concerned. It also means the market does not expect the RBI to raise rates to match the monetary policy tightening being undertaken by the US Fed.

If the long-term yields remain as steady as they have been over the last few months, and the RBI continues to tighten the short-term rates, we may soon see the term premium moving close to 0. For an economy growing roughly at 5-6% on average with an inherent inflationary impulse, such a flat yield curve implies that the market is anticipating a severe growth slowdown and hence monetary policy easing.

Is that indeed the case? The answer is: it is not possible to answer this anymore by looking at the yield curve. Let's understand why.

During the pandemic the RBI had expanded its balance sheet by around 25%. It bought long-term G-Secs and the 10Yyields were held steady around 6%. Since October 2021 it has stopped its bond buying program. At its peak the RBI’s balance sheet was around Rs 65 trillion in October 2021. Between then and September 2022 the balance sheet has shrunk marginally to around Rs 59-60 trillion. This means that while the RBI has been withdrawing short-term liquidity using the SDF and reverse repo facilities, it has not been selling long-term G-Secs.

Typically, the RBI withdraws long-term liquidity through open market operations (OMOs) or by selling dollars from its reserves. In the former case, the stock of G-Secs goes down, and in the latter, reserves fall. The RBI has lately been relying on the second mechanism - selling dollars - to reduce liquidity (and to stem the rupee depreciation). When the RBI’s GSec holdings were small, this did not matter. Now the RBI potentially holds around Rs 15 lakh crore worth of G-Secs which is tad below 20% of all outstanding G-Secs, compared to its peak holding of Rs 15.8 trillion in September 2021. In contrast, between 2011 and 2020, the average RBI ownership of G-Secs was roughly 11% of the outstanding. As long as the RBI continues to hold such a large amount of G-Secs, the long-end of the yield curve is unlikely to respond freely to economic conditions.

A natural way for the term premium to shrink is if inflation comes down or growth slows down. But if in some part of the market there are no transactions, and a large chunk of the supply of long-dated bonds is cornered then this hampers price discovery. All interest rate sensitive securities are directly or indirectly priced with reference to the yield curve. Any such distortion of the yield curve therefore will translate into an economy wide pricing distortion. This also hampers transmission of monetary policy along the yield curve.

The RBI itself has been advocating an “orderly evolution of the yield curve”, but its own decision has important consequences for the market in general and the yield curve in particular. The current compression of the term premium suggests that the yield curve is anything but orderly.

Why weaker rupee isn't all bad news

Times of India, July 22, 2022

Over the last few months, the exchange rate has come under intense pressure, falling to nearly Rs. 80 to the dollar, its lowest level ever. Some observers have argued that this pressure can be managed easily, since the country can simply sell a portion of its foreign exchange war chest, which amounts to a healthy $580 billion. Unfortunately, currency management is not that simple. In fact, it is not obvious that dollar sales will be sufficient to resolve the exchange rate pressure – or even whether preventing depreciation is the right strategy for the economy at present.

Let’s start by considering why the rupee has been under so much pressure. A key reason is that the US Federal Reserve has begun to tighten monetary policy aggressively to control inflation, which is at a four-decade high. The Fed has already raised interest rates by 150 basis points so far this year and is expected to tighten by a further 75 basis points later this month. When the Fed raises interest rates, global investor funds shift their portfolio allocations towards US financial markets, taking the money out of other countries. In India’s case, the net sales of foreign portfolio investors have amounted to a sizeable $31 billion in 2022 so far, according to data from NSDL.

The inflow of money into the US has led to an appreciation of the dollar. The dollar index (DXY) has strengthened against its trading partners by more than 11 percent this calendar year, reaching levels last seen in 2002. The counterpart to this appreciation has been a depreciation of the pound sterling, the euro, and nearly all Emerging Market (EM) currencies. In the case of the rupee, the depreciation has amounted to a relatively modest 7 percent since January 2022.

In fact, the rupee’s depreciation has been surprisingly modest, considering that at the same time that capital has been flowing out of the country, India’s current account deficit (CAD) has also been widening. Typically, the CAD increases when aggregate demand grows so rapidly that imports rise faster than exports. However, aggregate demand in the Indian economy has been tepid since the onset of the Covid-19 pandemic and the recovery has been slow and gradual at best. So why is the CAD worsening?

Much of the answer lies in the rapid growth of import prices. India is heavily dependent on imports of petroleum (which cover 80 percent of the country’s needs) and other commodities. And supplies of commodities have been disrupted since the Russia-Ukraine war started in February 2022, causing the prices of petroleum, fertilisers, edible oils, and other products to soar. This has automatically inflated the import bill, pushing the monthly trade deficit to an all-time high of $26 billion in June 2022. On current trend, the CAD for the fiscal year could reach 3-3.5 percent of GDP.

This has put India in a difficult situation. Just when the country needs more financing to cover a widening CAD, capital has started to flow abroad. That is why the rupee has taken a tumble.

So what can be done?

Without doubt, India can utilise some of its ample foreign exchange reserves – and indeed, it has already done so. However, this is not a complete solution. When the central bank sells foreign reserves, commercial banks need to give rupees in return, draining them of liquidity. Consequently, when reserve sales become large, the liquidity drain becomes sizeable, potentially tightening the money supply far more than what is appropriate, thereby endangering economic recovery.

To address this problem, the foreign exchange intervention can be “sterilised” if the central bank buys government securities from the banks. In that case, banks will receive rupees, thereby replenishing their liquidity. But if the central bank purchases large amounts of bonds, this could push G-Sec rates down to inappropriately low levels, thereby endangering the inflation target.

For these reasons, there is a limit to the amount of foreign exchange that the central bank can sell without jeopardising its other targets. And there is a further problem: since investors know that there is a limit to the foreign exchange sales, they will be tempted to try to purchase as much as they can right now. In that way, a policy of foreign exchange sales can sometimes – paradoxically – increase the pressure on the exchange rate.

In view of the complications arising from the strategy of selling reserves, it might help to go back to fundamentals and ask a deeper question: do we really want to prevent the rupee from depreciating?

After all, if the rupee fails to follow when other EM currencies are depreciating, then India’s exports will lose competitiveness. Already, the rupee has appreciated significantly against other Asian currencies such as the South Korean won, the Thai baht and the Taiwanese dollar. If competitiveness is further eroded just when the global economic environment is turning difficult, export growth could really suffer. And that might be a big problem.

The two most important drivers of growth for an emerging economy like India are investment and exports. Private sector investment has been sluggish for several years. Last year’s recovery was highly dependent on exports, which fortunately grew exceptionally rapidly. If this engine of growth starts to sputter, so might the economic recovery.

Of course, there are costs to a weak rupee. In particular, depreciation will push up prices at a time when inflation is already a problem. But there are other mechanisms for addressing inflation, such as increases in the repo rate, which indeed are already happening. In contrast, there are no other ready mechanisms to safeguard export competitiveness, apart from the exchange rate.

In sum, reserves can indeed be used to stabilise the rupee – but only to a certain extent. And there are some important advantages to allowing the rupee to weaken, as a way of supporting India’s economic recovery process. Striking the right balance is going to be a challenge not only for India, but for all emerging economy central banks.

What the MPC says and what the RBI does

Indian Express, June 22, 2022

Communication is an critical element of monetary policy. In the current inflation targeting (IT) regime, the resolution adopted by the Monetary Policy Committee (MPC) and published on the Reserve Bank of India’s website on the day of the monetary policy meeting is an important channel of communication with the public. Yet there seems to be a gap between what the MPC says and what the RBI does.

Under the IT regime, the most important role in communication belongs to the MPC, consisting of three external members, three RBI representatives, and chaired by the Governor. By law, this is the highest monetary policy-making body in the land, tasked with deciding monetary policy changes at regular intervals. These changes are then communicated through formal statements, with the discussions underlying these decisions also being published, so that the public can understand why the MPC decided the way that they did.

During the first few years of IT from 2016 to 2018, the process worked quite well. On the days of policy announcements, the Governor and his deputies would participate in a press conference to answer questions from the media. But otherwise the focus was squarely on the MPC, especially its statement, from which the public used to glean important information about the monetary policy strategy – that is, why the repo rate was or was not changed.

From 2019 onwards, however, things began to change. The RBI began to release a separate Governor’s statement on the day of the monetary policy meeting, presenting an inflation outlook and even explaining the decision taken by the MPC. The rationale for this statement was unclear: at best, it has overlapped with the MPC statement; at times, it has seemed somewhat different, making it difficult for the public to understand what the policy strategy really was.

Consider the MPC statement following the June 8 Monetary Policy Review. The MPC highlighted inflation concerns, and voted in favour of raising the policy repo rate. On the same day, a Governor’s statement issued by the RBI mentioned that the central bank will also remain focussed on orderly completion of the government’s borrowing programme.

The issuance of two such different statements can lead to confusion, especially as lowering inflation and lowering government bond yields are contradictory policy objectives. This is an example of how over the past few years, a communication gap seems to have opened up between what the MPC has been saying and what the RBI has been doing, thereby potentially eroding credibility of the IT framework. This communication gap will need to be closed in order for the RBI to become successful in bringing inflation back to its 4 percent target level.

Why is communication so critical? There are many reasons. But let’s focus on just one, namely the ability of the central bank to influence inflation expectations. If the public believes the central bank is committed to keeping inflation under control, then it will act accordingly. Firms will moderate their price increases, fearing that large price rises will make them uncompetitive. Meanwhile, workers will accept moderate wage increases, while investors will accept low interest rates on their bond purchases. With everyone acting in this way, it will be easier for the central bank to ensure that inflation indeed remains low.

Of course, spikes in commodity prices will inevitably cause inflation to surge from time to time. But if inflation expectations are well anchored, then it becomes relatively easy for the central bank to ensure that inflation returns to the target level before too long.

The most important task of the MPC, enshrined in the RBI Act (Amended), 2016 that introduced IT, is to decide the repo rate, since this has long been the lynchpin of India’s monetary policy framework. Ever since the early 2000s, policy had aimed to keep overnight money market rates in a corridor, with the lower bound established by the reverse repo rate and the upper bound by the repo rate. Since the width of this corridor was fixed, once the repo rate was decided, the reverse repo rate was automatically determined, and market overnight rates adjusted accordingly.

But during the Covid19 pandemic, the RBI constantly adjusted the reverse repo rate even as the MPC kept the repo rate unchanged, meaning that the fixed width of the corridor was lost, and accordingly the MPC lost any role in determining interest rates. Accordingly, the remit of the MPC and indeed the credibility of the entire IT edifice was called into question.

In addition, the RBI introduced a number of new policy instruments, again outside the remit of the MPC. During the pandemic, it brought in the GSAP program through which the RBI precommited to buying a certain amount of dated government bonds in order to control their yields. It then introduced variable reverse repo auctions, and more recently replaced the reverse repo rate with the long-dormant standing deposit facility rate, the rationale for which was not explained in the MPC statement. Unlike developed country central banks like the Bank of England for example, all unconventional monetary policy announcements were kept outside the MPC statement thereby raising questions about the role of the committee in deciding monetary policy actions at a crucial time like the pandemic.

Lastly, the RBI has been intervening in the foreign exchange market to manage the rupee. Forex interventions by definition influence the domestic monetary base and inflation. Yet the MPC in its monetary policy statements does not discuss either the exchange rate dynamics or the forex interventions. Just as it does not discuss the RBI’s interventions in the bond market to lower the yields.

The net result of all these actions is a potential loss of both clarity and credibility. There appears to be an growing rift between what the MPC says and what the RBI does. And with the proliferation of policy instruments, it is no longer clear to the public how the policy stance should be measured – or what the monetary policy framework is.

In its latest two statements, the MPC indicated that policy would now be focusing on bringing India’s inflation rate under control. If the RBI is going to be successful in this endeavour, the first step must be to close the communication gap, by reintroducing a simple and clear policy framework and restoring the central role of the MPC.

Rating RBI’s rate hikes

Times of India, June 9, 2022

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.