What RBI's letter to govt on missing inflation target is likely to contain

Failure to keep inflation between 2-6% for three straight quarters will require RBI Governor to explain to FinMin why target was missed, and steps MPC will take to achieve it going forward

The Reserve Bank of India expects consumer price index-based inflation to average around 6.7 per cent in FY23, with April-June quarter at 7.5 per cent, July-September at 7.4 per cent, October-December at 6.2 per cent; and January-March at 5.8 per cent.

With January-March FY22 headline retail inflation averaging 6.34 per cent, that would make it four consecutive quarters when inflation has breached the Monetary Policy Committee’s medium-term inflation target of 4 (+/-2) per cent.

As per the RBI Act, failure to keep inflation within 2-6 per cent for three consecutive quarters will require the RBI Governor to write to the Finance Ministry explaining why the inflation target was missed, and steps the MPC would take to bring headline retail inflation to that level. If the RBI’s projections hold true, this will happen after the July-September quarter.

This is a significant development because there is no precedent for such a communication, and thus the letter sent by Shaktikanta Das to Finance Minister Nirmala Sitharaman will set the template for the future.

The RBI Act was amended through the Finance Bill 2015 to enable the formation of the MPC.

Section 45ZN (failure to maintain the inflation target) of the Act notes: “Where the Bank fails to meet the inflation target, it shall set out in a report to the Central Government –– (a) the reasons for failure to achieve the inflation target; (b) remedial actions proposed to be taken by the Bank; and (c) an estimate of the time-period within which the inflation target shall be achieved pursuant to timely implementation of proposed remedial actions.”

To interpret the Act, an agreement on the Monetary Policy Framework, signed by the government of India and the RBI (signed by the finance secretary and the governor of the RBI), has been in operation since February 20, 2015. It was renewed in 2021.

Based on these criteria, the letter to the Finance Minister could contain the reasons for runaway inflation. The biggest of those is of course Russia’s invasion of Ukraine, which has disrupted supply chains and led to a spike in prices of crude oil and other commodities. Benchmark crude prices remain stubbornly above $100 a barrel.

This apart, the strict Covid lockdowns in China have also impacted global inflation. Domestically, some of the food items have seen a temporary spike in prices due to the severe summer season, and edible oil prices remain a concern.

On June 8, the six-member MPC unanimously decided to raise the repo rate by 50 basis points. This followed an off-cycle rate hike of 40 basis points, making it 90 bps rate hike in just a span of a little over a month, as inflation emerged as the biggest challenge facing central banks and governments around the world.

Days later, on June 16, The United States Federal Reserve raised its own interest rates by 75 bps, the biggest rate hike since 1994. The same day, The Bank of England on Thursday hiked its main interest rate for a fifth straight time, as it forecast British inflation to soar further this year to above 11 per cent. Economists say that such big rate hikes could be par for the course going ahead.

And this could be the crux of the second parRBI does expect CPI inflation to come down below the 6 per cent mark in the January-March quarter, but a lot of it depends on where crude prices go from here.

Its important to remember that RBI Governor Das will not be in direct communication with Parliament on the subject. Sitharaman will decide whether to table his communication in Parliament or not.

It means subsequent discussion, if any, in Parliament on the conduct of monetary policy under the RBI Act will be steered by the fiscal authority, the Finance Ministry.