To Tackle Inflation, RBI Needs to Learn From Its Recent Mistakes

The Reserve Bank of India’s Monetary Policy Committee (MPC) met recently to announce its quarterly statement. The committee announced an increase in the policy repo rate under the liquidity adjustment facility (LAF) by 50 basis points to 4.90% with immediate effect.

The standing deposit facility and bank rate were also adjusted further. The committee also decided to remain focused “on withdrawal of ‘accommodation’ to ensure that inflation remains within the target going forward, while supporting growth”. 

The central bank panel also acknowledged how Consumer Price Index (CPI) headline inflation rose further from 7.0% in March 2022 to 7.8% in April 2022 (in May 2022, this eased to 7.04%), reflecting a broad-based increase in all its major constituents. Food inflation pressures are accentuated, led by cereals, milk, fruits, vegetables, spices and prepared meals. Fuel inflation was driven up by a rise in LPG and kerosene prices. Core inflation (i.e., CPI excluding food and fuel) hardened across almost all components, dominated by the transport and communication sub-group.

In its outlook, the MPC projects inflation at 6.7% in 2022-23, with Q1 at 7.5%; Q2 at 7.4%; Q3 at 6.2%; and Q4 at 5.8%. On growth, the group acknowledged the presence of significant spillovers from prolonged geopolitical tensions, elevated commodity prices, continued supply bottlenecks and tightening global financial conditions nevertheless, all weighing heavily on the overall macroeconomic outlook. Taking these into consideration it expects India’s real GDP growth projection for 2022-23 to be around 7.2% with Q1 at 16.2%; Q2 at 6.2%; Q3 at 4.1%; and Q4 at 4.0%.

Analytical interpretation

It seems like a redundant exercise, digging deeper into growth model predictions projected by the RBI, or any other institution, especially at a time when the degree of global economic and political uncertainty, and the ‘spillover effects’ of existing exogenous (or external) crisis factors – from global stagflationary concerns to a war – are all weighing heavily on any nation’s macroeconomic positioning.

Even though the RBI thinks, India may clock an annual growth rate of 7.2% rate (when adjusted for inflation), other institutions like the World Bank have already slashed India’s GDP growth forecast to 7.5% (which is the second time the Bank has revised down its growth forecast for India in the ongoing financial year).

The key issue here for the RBI is inflation’, a problem that over the last two years it has miserably failed to stay on course. Initial trends were visible for much of 2021, before it started peaking early this year.

The central bank, whose mandate is to target low inflation and keep it within a reasonable limit, was seen to be keener on doing everything else – from exchange rate targeting to ensuring greater (and more favourable) terms for government borrowing – while playing down any significant concerns surfacing on the ‘inflation end’ as a “temporary occurrence”.

In terms of response, economist Josh Felman quite accurately described three key lessons that the RBI should and must have learnt from its post-2009 handling of high inflation when in December 2009, inflation started to rebound; by March 2010 it had soared to nearly 10%. It turned out that, contrary to expectation, food inflation was indeed influencing other prices. The RBI didn’t want to raise interest rates then (too) as it would endanger India’s nascent post-financial crisis recovery. It felt the rise in inflation was also explained by “exogenous” (external) factors and expected things to go back to normal after a “temporary phase”.

Fast forwarding the picture to 2022, the RBI seems to be caught in a similar situation now. It doesn’t want to raise interest rates (though it is trying to do so in its recent MPC statement) to avoid any significant spillover effects from a tough monetary policy stance to pass on to growth. Still, the three lessons, the RBI needs to learn from the 2009 saga, as Felman argues are:

• “Broad-based and sustained increases in food prices are dangerous, as they can set off a serious inflation fire. 
• Food price increases are particularly dangerous when interest rates are at exceptionally low levels, as this only fans the inflation flames. 
• In such circumstances, the RBI cannot sit on its hands. It needs to act quickly to douse the flames, by raising interest rates as fast as possible to normal levels and beyond.”

So far, it is difficult to assess the RBI’s medium-to-long term stance. One may only hope that its gross negligence in the discharge of its principal obligation i.e. to keep core inflation in check-will become its primary priority, instead of being seen to become a bank that is toeing the government line and seems to only care-caters to the macroeconomic priorities of the government. 

Inflation as an ‘invisible tax’

The pressing need to keep inflation in check for the RBI or any developing country’s central bank is more important than any other function, and while this may come at the cost of keeping expectations from growth lower (which no government would appreciate), there is an analytical logic to this policy priority.

For one, developing countries like India have other key structural issues embedded and any spillover effects from a sustained price rise – from its effect on cost of production to labour market wages – would exacerbate those issues, which may later go beyond the scope of what a central bank’s or even government’s toolkit may address.

India has widespread inequality and a broken, disjointed, highly informal labour market where the willingness (and ability) to pay for essential commodities, services and wages are significantly different across social, economic and other identity-based groups. Even a marginal 1-2% increase in core inflation rate over the short term, whether from the WPI or CPI side, adversely impacts the (lower) social economic class, imposing an unfair ‘invisible tax’ on them.

RBI should manage expectations with care

How can the RBI reassure the public that it has indeed learned from its mistakes and the lessons it would have drawn from a post-2009 response to high inflation and stagflation concerns? Well, that would require a tight rope balancing act, not a panicky, poorly explained rate increase.

First, don’t blindly follow the US Federal Reserve’s monetary policy moves. Rather, by providing a convincing assessment of India’s own core inflation outlook and risks; a detailed description of the RBI’s medium-to-long strategy in targeting inflation is needed now more than ever; combined with an explanation of why it is convinced ‘this strategy’ (if offered) would be sufficient to bring inflation back to the intended 4% in a timely fashion. This will require the RBI to push for greater independence and assert its autonomy to make decisions that may not go well with the finance ministry’s (or the Prime Minister’s Office’s) line of thinking. Else, the adverse costs of pursuing a path of ‘gross negligence and/or not creating a strategic action plan for the medium-to-long term (as the RBI did) may only further weaken India’s macroeconomic core, which already seems to be headed towards a ‘free-fall’ at the moment.