As MPC fails on CPI mandate, RBI's growth-inflation balance gets trickier

The central bank will now have to provide a report to the government explaining the reasons for the failure and the steps to be taken

On Wednesday, government data showed that India’s consumer price index-based inflation was at 7.41 per cent in September 2022. The data officially marks the failure of the Reserve Bank of India’s (RBI) Monetary Policy Committee to keep inflation within the mandated target range — for the first time since the six-member panel started to decide policy repo rate in October 2016. The RBI has to now give a report to the government. Business Standard decodes the steps ahead.

What is the RBI’s inflation target?
 

In August 2016, the government notified that the target for CPI inflation was 4 per cent, with the upper tolerance limit set at 6 per cent and the lower limit set at 2 per cent for five years. On March 31, 2021, the government extended the same till 2026.

The MPC is deemed to have failed to meet its target if average CPI inflation is higher or lower than the tolerance band of 2-6 per cent for any three successive quarters. Accounting for the latest data, CPI inflation has been above 6 per cent for three successive quarters. The MPC will now hold a meeting and then provide a report to the government elaborating the reasons for its failure.
 

The RBI will also have to give an estimate to the government as to how long it will take to bring inflation back on target and the corrective steps that it will take. The MPC chairman will have to convene a meeting of members within a month, to decide on the contents of the letter.
 

In recent media interactions, RBI Governor Shaktikanta Das has said that it would take around two years for inflation to head back towards 4 per cent. Dismissing speculations, Das said that the RBI would not make public its letter to the government, given that the information is privileged.

Why has inflation been elevated?
 

The September data marks the ninth straight month that inflation has been above 6 per cent — the upper tolerance range set for the MPC. It also marks the 36th month that CPI inflation has been above the 4 per cent target.
 

During the initial stage of the Covid-19 pandemic, inflation climbed as restrictions on movement caused severe supply-side disruptions. From May to December 2020, the MPC was precariously close to failing on its mandate as CPI inflation soared above the upper tolerance band. The RBI, however, had treated April and May 2020 as breaks in the CPI series due to difficulties in gathering data amid lockdowns.
 

While inflation was showing signs of moderating in early 2022, the start of the war in Ukraine in late February led to a huge upside risk to inflation in the form of surging global commodity prices. Global supply-side constraints also deepened due to the war. Adding to the global inflation risks is a recent hardening of domestic food prices, largely due to lower agricultural output.

“This is the ninth month in a row that inflation is above the RBI mark and it does not look likely to come down any time soon with prices of certain food products to be pressurised in coming months due to lower kharif output. Rice, pulse and oilseed production is likely to be lower this time,” Bank of Baroda’s Chief Economist Madan Sabnavis wrote.
 

The RBI has projected retail inflation at 6.7 per cent for FY23. According to MPC estimates, inflation will fall below the 6 per cent mark in the first quarter of the next financial year.

What does it mean for financial conditions?
 

Since May 2022, the RBI has raised the repo rate by 190 basis points to rein in inflation. The latest data clearly warrants more rate hikes and a shift away from surplus liquidity conditions in the banking system. Financial conditions are therefore set to get tighter, with banks shelling out more to borrow funds from the RBI and passing on rate hikes to customers seeking loans. Deposit rates are also set to rise further, given that credit demand is strong and surplus liquidity is dwindling.
 

“Headline CPI is expected to remain above the RBI’s upper threshold of 6 per cent in the remainder of FY23, supporting continued front-loading of rate hikes. Terminal repo rate is expected between 6.50 and 6.75 per cent, depending on the degree of Fed hawkishness,” IDFC First Bank’s economists wrote. The repo rate is currently at 5.90 per cent.

What is the growth outlook?
 

While the RBI has said that it aims to ensure a soft landing for the economy amid tighter policy, recent data suggests that the picture on growth is not a rosy one as the scars from the pandemic remain.
 

In September, the RBI reduced its GDP growth forecast for FY23 to 7 per cent from 7.2 per cent. This came after data showed that the first quarter GDP growth was at 13.5 per cent versus the RBI’s estimate of 16.2 per cent. In the last few days, a host of global institutions including the World Bank and the IMF have sharply lowered India’s growth forecasts.
 

Given that higher interest rates depress aggregate demand in the economy, the RBI’s efforts to tame inflation will inevitably affect growth.
 

“Meanwhile, the underperformance of IP growth for two consecutive months confirms that growth momentum is slowly losing steam after posting a strong recovery through Q2,” Nomura’s economists wrote.