Opinion
Is the monetary policy panel’s decision wise? Credible?
Summary
- The jury is out on whether its focus on a 4% inflation target will succeed even as it risks hurting growth
Call it one of the best kept secrets of modern free market economies: the fallibility of central banks. What else can possibly explain the hype in the run-up to meetings of their rate-setting committees—whether it is the Monetary Policy Committee (MPC) in India or the Federal Open Markets Committee (FOMC) in the US? Or the way commentators and market participants spend hours parsing every word in their monetary policy statements, and later in the minutes of the meetings released subsequently?
This is especially puzzling if one considers how often the US Fed and Reserve Bank of India (RBI) have got it wrong in recent times. Both have demonstrated, time and again, that there is no such thing as an infallible central bank, whatever former President of the European Commission Jacques Delores might have said about Germans and the Bundesbank. “Not all Germans believe in God, but they all believe in the Bundesbank."
Central banks, let us accept, are (almost?) as fallible as you and me. Not that they can be faulted for this, in a world where change is the only constant, where oil prices can swing from $94 a barrel (27 September) to $86 (4 October) in less than a week, where a war that the West thought was won even before the first shot was fired drags on more than a year after it started, central banks can, and do, make mistakes.
Nonetheless, thanks to the aura that surrounds them—an aura that cryptocurrencies tried, and failed, to dispel—almost anything they say or do, even when they do nothing (as in the latest instance with RBI and the US Fed), central banks hold markets, particularly financial markets, in thrall. In the specific case of RBI, what was meant to be a one-time pause on rate action in April 2023 has now become a prolonged one, with the MPC opting to retain the repo rate (at which the central bank pumps liquidity into the system) unchanged at 6.5%—for the fourth time in a row!
Despite this, most of us keep faith in the central bank.
Consider. Under the flexible inflation targeting regime adopted in 2016, RBI is charged with keeping overall or headline Consumer Price Index inflation within a range of 2-6%. A target range it has failed to achieve in seven out of the past 12 months! Indeed, the central bank’s inflation projections have repeatedly been off the mark.
As late as June 2023, the MPC had projected inflation in the second quarter (June–September 2023) at 5.2%, only to raise it sharply to 6.2% at its very next meeting in August 2023. Since the first two months have averaged 7.1%, the actual number is likely to be closer to 7%. Yet, RBI’s earlier estimate has barely moved—from 6.2% in August 2023 to 6.4% now.
But far from being daunted by the task on hand, and its repeated failure on the inflation front (admittedly, more due to sins of omission than commission such as a failure to withdraw its easy money policy in time), RBI says it is not going to rest content with getting inflation within the mandated range.
Rather, according to RBI Governor Shaktikanta Das, it is going to focus on bringing it down to the mid-point of RBI’s target range—i.e. 4%—on a sustainable basis.
Remember, this is a level not reached in close to three years. The last time inflation was down to little over 4% was in January 2021, when inflation touched 4.06%, only to increase to 5.03% the very next month.
Yet, rather than shrug off the Governor’s assertion as well-nigh impossible, markets seem to have taken his words seriously. Despite the ‘pause’, 10-year yields rose from 7.2 % to 7.4% after the RBI announcement.
In defence of RBI, it must be said that, unlike the Fed and central banks of developed economies, its writ runs, at best, over a relatively small part of the consumption basket.
In a scenario where food and fuel account for close to 60% of the country’s consumption basket and demand here is largely immune to changes in interest rates, RBI’s main policy instrument—the repo rate—affects only what economists call core inflation.
This is a fact borne out by the recent fall in core inflation, even as retail inflation rose during the past few months. This also explains the all-too frequent revisions in RBI’s estimates. But it fails to explain why markets hang on to its words!
However, the larger question that the country’s central bank, and indeed all of us, need to ask at this juncture is this: Given the reality of the growth-inflation trade-off, even ignoring the now largely discredited Phillips curve, how wise is it to give up the flexibility (wisely) allowed under our inflation-targeting regime and get fixated on a particular level that we have almost never reached, except in the breach rather than practice?
Recall what Jerome Powell, Chair of the US Federal Reserve, said about the FOMC’s continued fight against inflation. “Getting inflation sustainably back down to 2% (the Fed’s target) is expected to require a period of below-trend economic growth."
Do we in India want to go down that same route? Should we aim for a more judicious mix of growth and inflation, rather than take the ‘do whatever it takes’ path to get retail inflation down to 4%, ignoring the leeway allowed by law to the MPC, heedless of what it might do to growth? Posterity might want to pose that question to the present MPC.
