A question of compliance

Data limitations should not be an escape clause for not honouring obligations under the inflation targeting regime

Recent commentary in the media has noted with concern a subtle shift in the way the Reserve Bank of India (RBI) has dealt with the responsibility of honouring its inflation mandate. Many commentators rightly believe that the central bank may have erred by prioritising growth over inflation. The current phase of inflation may be transitory, but the Indian experience of inflation feeding more inflation cannot be easily forgotten. There is, therefore, a fervent appeal that the central bank should soon return to its primary mandate of adhering to the inflation target of 4 per cent, although with a permissible upper tolerance level of 6 per cent and a lower tolerance level of 2 per cent.

 Such commentary is largely fuelled by the recently released minutes of the RBI Monetary Policy Committee’s meeting in early June. Underlining the need for fiscal, monetary and sectoral policy support, the Committee “decided to retain the prevailing repo rate at 4 per cent and continue with the accommodative stance as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of Covid-19 on the economy, while ensuring that inflation remains within the target going forward.”

 It could be argued that the Committee took a conscious call to unanimously prioritise growth over inflation. They were presumably influenced by the fact that retail inflation, measured by the Consumer Price Index (CPI), had stayed below the upper limit of the tolerance band from December 2020 to April 2021. The data for May 2021, which showed inflation breaching the upper limit of 6 per cent, had not been released when the Committee met in early June.  

 There may have been another factor — the forecast for retail inflation during the current year. CPI-based inflation was projected at 5.1 per cent during 2021-22, while the quarterly inflation numbers were expected to be 5.2 per cent in the first quarter, 5.4 per cent in the second quarter, 4.7 per cent in the third quarter and 5.3 per cent in the fourth quarter of 2021-22. Given such inflation rate projections, the Committee presumably decided to push for growth at a time the Indian economy needed to recover as quickly as possible from the ravages of the second wave of Covid-19.  

 The worry, however, is what happens if these inflation projections go wrong. The impact of the localised lockdown in different parts of the country is yet to be fully reflected in retail inflation. The June retail inflation number will have to decline to around 5 per cent if it must stay in line with the projection of 5.2 per cent for the first quarter. Will that happen? Remember that the inflation rates in April and May were 4.2 and 6.3 per cent, respectively!

 The bigger worry is if retail inflation stays above the upper limit of 6 per cent for the next few months or three quarters. The worry is not just on account of the adverse impact on the economy, but also on account of the implications for the Committee’s compliance of a key provision under the inflation targeting regime, which was introduced from 2016 through an amendment in the RBI Act.

Illustration: Binay Sinha

According to the compliance provision, average inflation staying above 6 per cent and below 2 per cent for any three consecutive quarters would mean a failure to achieve the inflation target. When such a failure takes place, the RBI must submit a report to the Union government stating the reasons for failure, remedial actions proposed to be taken by it and an estimate of the time within which the inflation target should be achieved “pursuant to timely implementation of the proposed remedial actions.”

 There is reason to worry on this count. The last time retail inflation did exceed the upper tolerance band of 6 per cent for more than three consecutive quarters, there was no such report from the RBI to the Union government. Average retail inflation stayed above 6 per cent for as many as four consecutive quarters — from the quarter ended March 2020 to the quarter ended December 2020.

 The reason such a report was not provided by the central bank was the Monetary Policy Committee’s decision in August 2020 to treat the inflation data for April and May 2020 as imputed. It had noted that the inflation numbers for these two months were collected under the limitations of the lockdown that prevailed in the whole country during that period. The Committee noted that “for the purpose of monetary formulation and conduct, therefore, the MPC is of the view that CPI prints for April and May can be regarded as a break in the CPI series”.

 The logic of treating the inflation data for these two months as a break in the CPI series was questionable. At the time of amending the RBI Act and justifying the need for a tolerance band of 2 per cent either way over the 4 per cent inflation target, the government had clarified that this leeway was granted to account for “data limitations, projection errors, short-run supply gaps and instability in agriculture production.” The tolerance band was also expected to “accommodate unanticipated short-term shocks even while nudging public inflation expectations on the centre of the range, to which the monetary policy will return the economy over the medium term, leading to transparency and predictability.” Most importantly, the tolerance band was expected to allow the MPC to recognise the short-run trade-offs between inflation and growth and enable it to pursue the inflation target in the long run over the course of a business cycle.

 So, why were the April-May 2020 inflation numbers treated as a break in the CPI series? If there were data limitations, weren’t the tolerance bands introduced precisely to take care of such situations? The only possible reason for the Committee’s decision was to break the chain of three consecutive quarters over which the inflation rate had stayed above 6 per cent and obviate the need for both accepting failure and explaining to the government what the central bank was planning to do to keep inflation under control. This was problematic for two reasons. One, the Committee had taken the easy way out by not explaining to the government what its perspective was on inflation. Two, the government also failed to secure from the RBI a report on inflation, whose trajectory should be as big a concern for it as growth.

 The second wave of Covid-19 may have already adversely impacted data collection for May and June of 2021. And if India is indeed entering into another phase of high inflation, then it is perhaps important for both the government and the RBI to not seek recourse to data limitations and justify that to avoid an explanation on the inflation situation. The need for presenting such a report would bring attention back to the need for reining in inflation. More importantly, the report would help generate a public debate on this vital issue affecting the people and, hopefully, help the government explore policy options to limit the impact of higher prices on its citizens.