Inflation targeting in letter and spirit

There have not been good enough reasons outside of the RBI for inflation to have stayed above 6 percent

The Reserve Bank of India (RBI) is supposed to target 4 per cent inflation, as measured by the consumer price index, with a leeway of 2 percentage points, which is actually a leeway of 50 per cent (2/4 x 100). However, for the last three quarters, the actual inflation rate has been well above the upper limit of 6 per cent. The RBI held a meeting on November 3 to draft a letter of explanation to the Government of India (GoI).

Though the RBI’s formal explanation has not been made public so far, it is quite clear from various other statements that the RBI was concerned about economic growth, and factors like the invasion of Ukraine by the Russian government. However, the RBI’s defence is not strong.

It is true that the inflation rate in India is currently less than that in the US or Europe. However, the RBI has been much better placed than the Federal Reserve System (Fed) or the European Central Bank (ECB). The Fed has had to deal with an excessive fiscal stimulus by the US treasury, and the ECB has had to deal with inflation, given a very serious energy crisis. The RBI did not face either of these situations in India.

The fiscal stimulus in India in the aftermath of Covid-19 has not been excessive at all. And, due to the invasion of Ukraine, we are getting oil at relatively low prices from Russia. Also, the GoI and state governments have reduced taxes on fuel over the last year or so. This too reduced inflationary pressures. It may be argued that food prices could have played a role in the high inflation. But even the average core inflation rate over the last one year or so is close to 6 per cent. Why?

We may go back and blame Covid-19 for many of the outcomes. However, Covid-19 and the related lockdowns and restrictions had adversely affected basically the supply side in the economy in 2020-21. So, on the demand side, the role of an expansionary monetary policy by the RBI in such a situation was actually limited — more so, when banks were anyway finding it difficult to find decent borrowers for the funds available.

A basically supply-side story and the related need to ease supply have somewhat continued even in the phase of recovery and consolidation over the last year or so. And, the RBI cannot help in this. But if the monetary policy is nevertheless geared towards above-optimal expansion, it is not surprising then that inflation rate rose substantially.

Though the inflation rate has crossed 6 per cent over the last three quarters, it has remained somewhat above the target of 4 per cent for more than three years now! The above-optimal expansion in money, and lowered interest rates have been in place since 2019. It is only since May this year that the RBI is moving towards normal rates. Lower inflation will come with a significant lag.

There are reasons to believe that the RBI’s attempt before May was only to ensure that the inflation rate should not cross 6 per cent so that it did not violate the letter of the policy regime. However, if it was not really targeting 4 per cent inflation, then it was violating the spirit of the policy regime. Eventually, it found itself violating even the letter of the policy regime when the inflation rate crossed 6 per cent for three consecutive quarters, once in 2020 and now in 2022.

Observe that if 4 per cent inflation is targeted, the actual inflation may at times go up to 6 per cent. So, if the RBI were to de-facto target inflation at, say, 5.5 per cent, then the actual inflation rate may go up to about 7.5 per cent, which is, in fact, what has actually happened now.

At the cost of over simplifying, high inflation in recent years in India has been, when all is said and done, primarily a story of low interest rates and high money growth. The RBI’s objective was to deal with the economic slowdown, but there are different kinds of slowdowns and a reduction of interest rates is not a solution in all cases.

It is interesting that once inflation targeting has been adopted, hardly any country has abandoned the policy even after a variety of crises over the last two-three decades. If the RBI also continues with inflation targeting, and it does seem inclined, then it should follow the mandate worked out over the long period between 2013 and 2016 in letter and in spirit.

All this is not to say that the inflation rate should never cross 6 per cent for three quarters. But there have not been good enough reasons for this outside of the RBI in 2020 or in 2022.

The writer is visiting professor, Ashoka University. gurbachan.arti@gmail.com