How RBI went wrong on inflation

The RBI governor, Shaktikanta Das, did not acknowledge the inflation problem for a while. Photo: Mint
The RBI governor, Shaktikanta Das, did not acknowledge the inflation problem for a while. Photo: Mint


  • For a long time, India’s central bank didn’t think that inflation was a problem.

MUMBAI : Earlier this month, Shaktikanta Das, the governor of the Reserve Bank of India (RBI), compared the Indian central bank to Arjuna in the Mahabharata.

“When the great warrior Arjuna aimed at the eye of the revolving fish through the pool of water below, he would have certainly assessed the speed at which the fish was revolving, the wind conditions, the intensity of the ripples in the pool of water, the noise levels in the King’s court and similar other factors," he said. While “no one can match the prowess of Arjuna," Das added, “our constant endeavour is to keep an Arjuna’s eye on inflation, which is our primary target."

Growing woes
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Growing woes

In simple English, like Arjuna’s unwavering focus on the revolving fish, the RBI is focussed on inflation, or the rate of price rise.

Das clearly has a way with words. Nonetheless, the trouble is that these fancy words come after the Indian central bank failed to meet its inflation target of 4%.

In this piece we look at RBI’s inflation mandate, why it failed to meet it, and how it is currently trying to play catch up.

RBI’s inflation mandate

In February 2015, the RBI entered an agreement on the monetary policy framework with the central government. As per this agreement, the RBI needs to target an inflation of 4% as measured by the consumer price index (CPI), with a leeway of 2% on either side. This means that inflation needs to be within a band of 2-6%, for the RBI to ensure that it doesn’t break its agreement with the government.

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Take a look at Chart 1. It plots the inflation as measured by CPI, or the retail inflation, over the last few years.

The retail inflation, in each of the months since January, has been higher than 6%. In fact, the median inflation during this period was 7%. RBI’s monetary policy framework agreement with the government clearly states that the central bank would be seen to have failed to meet its target rate of inflation, if the inflation was more than 6% or less than 2%, for three consecutive quarters. As stated earlier, inflation from January to September has been higher than 6% in each month, or for three consecutive quarters. This is the first time the RBI has failed to meet its inflation target, since it entered into an agreement with the government.

In fact, a similar situation almost came about in 2020. In each month from April to November during the year, the retail inflation was higher than 6%. The inflation in December came in at 4.6% and thus ensured that the RBI did not fail to meet its targeted rate.

What does the RBI need to do?

The monetary policy framework mandates that when it fails to meet the target rate of inflation, the RBI has to submit a report to the government explaining the following points:

1) Reasons for the failure to achieve the inflation target.

2) Remedial actions proposed to be taken.

3) An estimate of the time period within which the inflation target shall be achieved pursuant to timely implementation of the proposed remedial actions.

The monetary policy committee of the RBI met on 3 November to discuss and draft this report that needs to be submitted to the government. This report is unlikely to be made public. As Das put it: “It’s a report sent under a law, I don’t have the privilege, the authority or the luxury to release…this."

What caused high inflation?

The conventional explanation is that the inflation was primarily driven by high food prices and high oil price. The food items form a little over 39% of the total number of items that go into measuring the consumer price index. Given this high weight, food prices do have a disproportionate impact on retail inflation as it is measured.

The median food inflation from January to September stood at 7.7%, slightly higher than the overall median inflation of 7%. In recent months, high inflation in cereal prices has been driving food inflation, among other things. In September, cereal prices rose by 11.5% in comparison to September 2021.

Of course, there isn’t much that the RBI can do to control food inflation, goes the argument. Nonetheless, the rise in retail prices has not just been because of food and fuel prices. Take a look at Chart 2. This plots the core inflation or inflation that remains after excluding the food group, the fuel and light group, and petrol, diesel and other fuels for vehicles. This core inflation is calculated using around 52% of the overall items that constitute the consumer price index.

In every month since June 2020, the core inflation has been higher than 5%. In every month since October 2021, the core inflation has been higher than 5.5%. In September, it hit 6.5%. The point being that while food and fuel inflation have played a role in pushing up overall retail inflation, even core inflation has been higher than RBI’s target of 4% for a while now. This means that inflation is a much broader economic phenomenon and not just about food and fuel items.

In fact, diesel prices for vehicles, despite being high, have fallen in each of the months from July to September in comparison to last year. Petrol prices have fallen in August and September in comparison to the same months in 2021.

Why did RBI fail?

This is the most important section of this piece given that the RBI report to the government explaining the reasons behind the central bank being unable to meet its inflation target is unlikely to be made public.

The first step towards solving a problem is acknowledging that it exists. The RBI governor, Shaktikanta Das, did not acknowledge the inflation problem for a while. In December 2019, he said: “The forces driving up inflation appear to be transient".

The inflation in December 2019 and January 2020, before the covid-19 pandemic had struck, stood at 7.4% and 7.6%, respectively. Retail inflation was hardly transient through 2020 and remained high. Of course, Das should be given the benefit of doubt here. He, or for that matter anyone else, had no way of knowing in advance that a pandemic would strike and disrupt supply chains and economic production through much of the year.

In October 2020, Das said: “The monetary policy committee has hence decided to look through the current inflation hump as transient." Retail inflation fell to 4.6% in December 2020 and 4.1% in January 2021, respectively, but then rose again over the next few months.

In August 2021, Das again said: “The recent inflationary pressures are evoking concerns; but the current assessment is that these pressures are transitory."

The thinking of the monetary policy committee (MPC), which in order to control inflation, decides on the direction of interest rates in the Indian economy, hasn’t been much different from that of Das. In October 2021, the MPC said: “The CPI headline momentum is moderating with the easing of food prices which, combined with favourable base effects, could bring about a substantial softening in inflation in the near-term." The median retail inflation has stood at 7% from November 2021 to September. The median core inflation has been at 6% during the period.

In February 2022, the MPC noted “that inflation is likely to moderate in H1:2022-23 (April to September) and move closer to the target rate thereafter". Nothing of that sort seems to have happened. The median rate of inflation from March to September has been 7%, significantly higher than the targeted rate of 4%.

Clearly, there is enough evidence and more to suggest that the RBI didn’t think that inflation was a problem for a long time, when it actually was. Of course, a significant portion of the inflation in the recent past has been because of food items, but as shown earlier in the piece, inflation is now well-entrenched in the overall economy.

In fact, as former RBI governor Raghuram Rajan had said in a 2016 speech: “Some argue, rightly, that it is hard for RBI to directly control food demand through monetary policy. Then they proceed, incorrectly, to say we should not bother about controlling CPI inflation."

Of course, the RBI can’t do much to control food demand and prices; only the government can influence that.

Nonetheless, Rajan pointed out: “We can control demand for other, more discretionary items in the consumption basket through tighter monetary policy. To prevent sustained food inflation from becoming generalized inflation through higher wage increases, we have to reduce inflation in other items."

What did the RBI finally do?

On 4 May, the RBI raised the repo rate by 40 basis points to 4.4%. One basis point is one hundredth of a percentage. Repo rate is the interest rate at which the RBI lends to commercial banks.

The funny thing is that as per the original calendar released for the financial year 2022-23, there was no monetary policy meeting scheduled in May. The RBI was forced to meet in May because the US Federal Reserve, the American central bank, was meeting on 3-4 May and it was more or less clear by then that the Fed would hasten the pace of interest rate hikes in order to control decadal high inflation in the US. Given that the US sets the tone of global monetary policy, the RBI had no option but to start raising rates in May.

What next?

A recent news report by the Press Trust of India points out: “Acknowledging that the inflation target has been missed, [Shaktikanta] Das said the RBI decided to support the economy by not introducing a rate hike in face of a spike in inflation."

This is saying something with the benefit of hindsight simply because as shown earlier in the piece, up until February, the RBI thought that inflation was either transitory or was expected to moderate. And given this, there was no question of raising interest rates to control inflation because the RBI did not deem persistent inflation to be a problem.

In fact, there might be an explanation for RBI’s reluctance to acknowledge persistent inflation that has prevailed since late 2019. Once covid broke out, the tax collections of the government collapsed. In this scenario, as the public debt manager of the government, the RBI had to help the government borrow money at low interest rates, so as to be able to fund its expenditure. So, low interest rates had to be the order of the day, despite the inflation being high.

If the RBI had acknowledged persistent high inflation as a problem, then it would have become very difficult to explain as to why it wasn’t raising interest rates. No central bank worth its salt would come out and directly say that they aren’t currently bothered about inflation, but are more interested in supporting the government.

Nonetheless, while this argument made sense in 2020-21, it didn’t make much sense in 2021-22, when the government tax collections did make a significant recovery. Given that there is a time lag between interest rates being increased and inflation being brought under control, the RBI should have started increasing interest rates in the second half of 2021, like many other central banks of developing countries did. (They still haven’t been able to control inflation and that tells you something about the lag between interest rates and inflation and how difficult things become once inflation becomes well entrenched).

Finally, there is the growth argument: we didn’t raise interest rates because we wanted to support the economy. It’s worth remembering here that high inflation does pull down economic growth. Further, high inflation negatively impacts the poor and the not-so-well-off more than the others. Hence, in a developing country like India, controlling inflation should be as important as supporting economic growth, if not more.

Vivek Kaul is an economic commentator and a writer.

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