RBI's secret letter on missed inflation target: what the MPC minutes tell us

The RBI has failed to bring the inflation rate below the upper limit of 6 per cent in the last three quarters, or nine months. Inflation has remained above the target of 4 per cent for more than three years now, or pretty much through the tenure of Governor Shaktikanta Das, who, as Economic Affairs Secretary in the Modi government, steered the amendments to the RBI Act through Parliament. He also coordinated from the government side with the central bank for the transition to the formal inflation-targeting regime through which New Delhi had aimed to strengthen the RBI’s credibility and accountability, as ultimately it is the political class that gets questioned and often penalised by voters for price rise. He is now complying with the amended law — and he is the RBI’s first governor to have failed on the inflation target.

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The amended law requires the RBI to explain in writing the failure to keep inflation within the tolerance limits for three consecutive quarters, the reasons for the failure, and the steps the central bank plans to take to bring inflation back in control. The RBI’s Monetary Policy Committee (MPC) met on November 3 to prepare this letter of explanation to the government. Das has said that the RBI would not make the explanation being sent to the government public. However, it is expected that the government will make it public since inflation and the RBI’s failure is a matter of public — and Parliament’s — scrutiny. 

If it doesn’t, the statements made by the MPC members in the recent meetings can be a good indicator of what the RBI’s letter of explanation is likely to contain. Mint SnapView studied the official minutes for potential pointers. 

The statement by RBI’s deputy governor Dr. Michael Debabrata Patra in the minutes published on October 14, 2022 suggests that the central bank could plead not guilty by arguing that global factors made it difficult to project inflation and complicated its monetary policy choices and their effectiveness, all which means large sacrifices of growth will be required for tamping down prices. It may skilfully deflect the accountability at the doorstep of systemic central banks (the US Federal Reserve in other words) and contend that much of the inflation in India is imported inflation. Dr. Patra’s statement also suggests that the RBI does not see itself in a position to bring inflation under control before 2022 or even 2023. 

This inflation shock defeats conventional forecasting models. The parameters that characterise recent developments are far outside the ranges predicted by the conventional models. …currently available projections of inflation suggest that the real policy rates will remain negative up to close of 2022. Hence, more forceful tightening of monetary policy in 2023 may be required if terminal rates have to be achieved...

For net commodity importers like India, with over a third of the CPI being imported, a negative terms of trade shock convolutes macroeconomic management...

No country is immune. Systemic central banks should pay heed to the possibility that today’s spillovers can become tomorrow’s spillbacks...

The RBI’s forward-looking surveys suggest that selling prices in manufacturing and services may rise further as pass-through from input cost pressures remains incomplete. Exchange rate volatility is amplifying these core price pressures...

His statement in the minutes published on August 19, 2022 adds the Covid-19 relief stimulus in advanced countries to the list of reasons for the RBI’s failure.

With inflation remaining elevated worldwide and a pervasive sense of guilt about the consequences of the pandemic stimulus having been underestimated, central banks have launched into the most aggressive, front loaded and synchronous monetary policy tightening in decades…

In the same statement, Dr. Patra also addressed the question on what the RBI is doing for controlling inflation by explaining that it is frontloading interest rate hikes.

Monetary policy’s response to supply shocks has to be predicated on managing expectations and fortifying credibility…By frontloading monetary policy actions, credibility is demonstrated by showing commitment to the inflation target.

The statement by Dr. Shashanka Bhide in the minutes published on August 19, 2022, suggests that the prolonged Russia-Ukraine conflict and disruptions in supplies will be one of the reasons the RBI will give in its explanation letter.

Prolonged Russia-Ukraine conflict and disruptions in supplies, especially for energy and food commodities are a major source of uncertainty for price trends. The direct impact of supply disruptions, even if targeted to some geographies, is quickly transmitted elsewhere to meet the overall demand supply imbalances.

The statement by the RBI’s Executive Director Rajiv Ranjan in the minutes published on June 22, 2022, made similar points on the sources of inflation. 

The ongoing war in Europe and the consequent sanctions have taken a heavy toll on the global economy by aggravating supply chain disruptions and heightening uncertainty about the post-pandemic recovery. With inflation scaling multi-decadal peaks across several countries and remaining stubborn, risks of long-term inflation expectations getting unhinged have increased manifold leaving monetary authorities with little room to manoeuvre. 

His statement in the minutes published on August 19, 2022 indicates that on the steps it has taken for fighting inflation, the RBI is likely to point to the rate hikes starting from the unscheduled MPC meeting in May this year. 

Inflation expectations of households in India, being adaptive and backward-looking and influenced mainly by price expectations of food and fuel items (which constitute almost 55 per cent of the CPI basket), moderated in the July 2022 round but remained at elevated levels. Unmooring of inflation expectations, in the context of the spike in inflation following the conflict in Europe, is the biggest risk which the MPC addressed through the off-cycle meet and frontloaded rate actions so as to increase the efficacy of the actions.

The statement by Prof. Jayanth R. Varma in the minutes published on October 14, 2022 suggests that RBI could say it would need up to six quarters or 18 months to bring inflation into control even after taking the repo rate up to around 6 percent.

It may take 3-4 quarters for the policy rate to be transmitted to the real economy, and the peak effect may take as long as 5-6 quarters. If we raise the repo rate to around 6 percent at this meeting, that would be a cumulative increase of around two percentage points in the space of just four months. Even this understates the extent of monetary tightening, because, a few months ago, money market rates were close to the reverse repo rate (65 basis points below the repo rate). Taking this into account, the full magnitude of monetary tightening would be well over 250 basis points.

Much of the impact of this large monetary policy action is yet to be felt in the real economy…

…since monetary policy acts with lags, what is relevant is the inflation forecasts 3-4 quarters ahead. Both the RBI’s forecasts and the survey of professional forecasters show inflation falling to around 5 percent in the first quarter of the next financial year. 

Do these points mitigate the RBI’s failure? Not really. The RBI has not had to deal with loose fiscal policy of the sort the US treasury opted for and stimulated the US economy with. Second, India has not suffered a food prices crisis after the war broke out in Ukraine because of the comfortable buffer stocks policy and the Modi government’s scheme for providing free foodgrains. On energy inflation also the pressure is less, as India is buying discounted crude oil from Russia. It’s unconscionable that stripped of food and fuel prices, inflation in India (what economists call core inflation) has averaged at the upper tolerance limit of 6 percent for over a year now. 

If CPI inflation has remained higher than the target level of 4 per cent for three years now, it is because the RBI has not taken the inflation target seriously. It was quite comfortable with inflation at 6 per cent, and instead committed itself to boosting growth, but delivered neither a revival in private investments, essential for quality GDP growth, nor low inflation. It was content to limit itself to liquidity operations all along. The MPC started raising interest rates only after inflation crossed the upper tolerance limit, knowing well monetary policy shows results with lags.

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