How RBI missed the inflation surge

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) will meet next week for the first time since increasing the policy repo rate by 40 basis points after an off-cycle meeting on May 4. Given the inflation condition, another rate hike is said to be a “no-brainer”. Financial markets are expecting the rate-setting committee to increase the policy rates by 50 basis points next week. A rapid rise in consumer price levels is forcing central banks across the world to withdraw monetary accommodation and increase interest rates. Higher inflation has become the primary policy challenge. The urgency to contain inflation has increased in India as well and an off-cycle meeting to increase the policy rate underscored that the central bank has fallen behind.

To be fair, not much changed between the April and May meetings of the MPC. The next week’s meeting would be closely watched for the revised inflation projections. Several private-sector economists expect the inflation rate to remain above the upper end of the tolerance band for the rest of the year. Reduction in fuel taxes and other measures by the government would only have a marginal impact. Average inflation above the tolerance band for three consecutive quarters, according to the law, would be treated as a failure to attain the target. This would warrant an explanation by the central bank along with the proposed action.

The RBI did most of the heavy-lifting in the initial phase of the pandemic but was slow in unwinding the policy accommodation as economic reality changed. While the MPC reduced the policy rate sharply, the RBI flooded the system with liquidity. The initial weeks of the pandemic were extremely uncertain and the central bank did well by injecting liquidity to contain friction in the financial system. However, to bring down market interest rates, it reduced the reverse repo rate disproportionately, which made the MPC practically irrelevant. The reverse repo rate is not under the purview of the MPC and with excess liquidity, it became the operating rate. If lower market rates were necessary, the policy repo rate should have been reduced through the MPC. Bypassing the committee dented the RBI’s credibility as an inflation-targeting central bank.

It is worth noting that the policy corridor under the liquidity adjustment facility was normalised with the introduction of the standing deposit facility in April 2022. The idea clearly was to keep market interest rates low, partly to complete the government borrowing at lower rates. The RBI thus maintained significantly higher levels of liquidity for far too long. As the RBI’s recent Report on Currency and Finance highlighted, higher liquidity affects inflation outcomes and the impact has apparently increased in recent years.

One of the reasons why the RBI delayed liquidity normalisation is the underestimation of inflationary pressures. It was fairly evident in the initial months of the pandemic that a collapse in demand was not having a corresponding impact on prices. In fact, disruptions seem to have pushed up prices. The average inflation rate in 2020-21 was 6.2 per cent. It is also worth noting that India was witnessing higher inflation even before the pandemic. Notably, the average inflation rate remained above the tolerance band for over three consecutive quarters in 2020. But it was not considered a failure because April and May 2020 were treated as a break in the series due to data collection difficulties during the lockdown.

It can be argued that if the inflation numbers for the above-mentioned period were accounted for and the RBI had to explain why it missed the target, it would have been in a better position to strike the right balance between maintaining price stability and supporting growth. Since it was a period of extreme uncertainty, such an action would have increased the RBI’s credibility.

As the RBI gave more importance to growth, the objective of price stability became secondary. The central bank’s communication gave an impression that it was comfortable as long as the inflation rate remained below 6 per cent — the upper end of the tolerance band. As recently argued by the central bank, in terms of sequencing of priorities, it had put growth ahead of inflation. Although it has now put inflation before growth, it is worth debating if the RBI is expected to do this sequencing at all. According to the RBI Act, “the primary objective of the monetary policy is to maintain price stability while keeping in mind the objective of growth”. The sequencing changed the primary objective. The purpose of having a range around the target is to allow the MPC to accommodate growth concerns in case of shocks in the short term. Adjusting the policy objective and tolerating inflation can affect expectations.

Besides it’s being argued that inflation has spiked because of the Ukraine war. Also, India is not the only country witnessing such a problem. There are two important points worth mentioning here. First, it is correct that prices have gone up in recent months because of the war, but India has been facing inflationary pressure for a while.

Second, comparison with advanced economies must be done carefully in the context of inflation. Expectations in some of those countries are well anchored and, in fact, the central banks there had been trying hard to push up inflation for years. The condition in India has been very different and, over the years, the RBI has tried hard to contain inflation, including with the introduction of the flexible inflation targeting framework. Therefore, India should have been more careful.