Is RBI going to get a notice on inflation?

The data on India’s consumer price index (CPI)-based inflation, also known as retail inflation, for July, and the wholesale price index (WPI)-based inflation, both calculated on a year-on-year basis, were released on August 12 and 16, respectively. Both were published only after the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI), which met on August 3-5 to set the interest rate for the next two months. So, MPC members were unaware of the mounting challenges the economy faces as it celebrates 75 years of Independence.

The retail inflation (6.71%) in July eased from the June figure (7.1%). However, the tolerance level, defined as the target rate (4%), agreed to between the government and RBI, plus an upwardly allowable margin of 2%, totalling 6%, has been breached for the seventh consecutive month since January. Inflation worries continue as it is above 6%.

This was despite an increase of 40 basis points (bps) in the repo rate at a regular bimonthly meeting of the MPC in May and another 50 bps at an emergency meeting in June, in all taking the policy rate from 4% to 4.90% as part of moving away from the expansionary phase to fight the Covid-induced recession since mid-2020. Seeing the need for another rise in interest rate, the August MPC decided to raise it further to 5.40%, higher than the pre-Covid interest rate of 5.15%, an extraordinarily hawkish step. The RBI Governor said it was “the new normal”.

Too late a realisation?

Tobias Adrian and Fabio Natalucci of the IMF wrote in their blog on August 10 that central banks of both advanced and emerging market economies, which supported economic recovery in the face of Covid-induced recession with interest rate cuts and asset purchases, changed their gears quickly soon after inflationary pressures rose on the horizon. They observed: “With inflation at multi-decade highs in many countries and pressures broadening beyond food and energy prices, central banks have pivoted toward tighter policy in many emerging markets (and) proactively started to hike rates earlier last year, followed by their counterparts in advanced economies in the final months of 2021.”

There were two notable exceptions: the US Federal Reserve (the Fed) until March, and the RBI, until May this year. The US inflation has been way off the Fed’s target rate of 2% for more than a year. From 5.3% in August 2021, inflation steadily rose to 7% in December and reached 9.1% in June 2022. Just as Indian inflation cooled off in July following a fall in prices of commodities, including food grains and edible oils, as the supply situation improved slightly with a decreasing trend in crude prices, though with volatility due to fear of recession, US inflation fell to 8.5% in July.

The US Fed had all along resisted raising interest rate, arguing that the factors influencing the rise in price levels were transitory. The US Fed’s chair admitted much earlier, on November 30, 2021, in his testimony to the US Senate Banking Committee that it was time to quickly wrap up the large-scale purchase of bonds, which was pumping up money supply. But he had taken too long to realise the unmistakable sign that the world economy was recovering from the Covid-induced recession as the crude price was rising. It was only the Russia-Ukraine war, which broke out in February 2022, that triggered the Fed’s tightening stance. Growing disruptions in supply of crude, natural gas, and food grains, as Ukraine was a leading wheat exporter, resulted in increase in commodity prices. The US Fed raised the rate only in March.

The RBI was also using the phrase “transitory and transient factors” for a while and delayed the tightening of easy money policy. Only in late May did it begin a series of anti-inflationary measures with a small rise by 40 bps in May, 50 bps in June and another 50 bps in August, in all 140 bps since May.

Was RBI late to act?

That is a question that will have to be formally examined in the event of a persisting inflation above the tolerance level in August and September. Under the RBI Act, if inflation is above 6% for three consecutive quarters, or nine months beginning from January 2022, the central government can ask the RBI why the monetary authority had failed to keep inflation below 6%.

The notice would, however, create an awkward situation for the government, too, raising the question whether the government had interfered with central bank autonomy. It remains to be seen if such a notice gets issued at all.

(The writer is a former Senior Economist, Asian Development Bank, and presently a Honorary Adjunct Professor, Amrita Business School)