Number Theory: A challenging phase for India’s inflation targeting framework


On May 4, the Monetary Policy Committee (MPC) of the Reserve Bank of India announced an unscheduled hike in the policy rate and increased the deposits banks need to maintain as cash with it — both measures aimed at reducing liquidity to fight inflation. The decision came a month before the scheduled MPC meeting in the first week of June, and was justified on account of significant upside risks to inflation compared to what the MPC saw in its April meeting. What explains such a decision? An HT analysis suggests that the unscheduled monetary tightening might be the first acknowledgment of what is likely the beginning of the most challenging phase in India’s six-year-old inflation targeting framework. Here are four charts which explain this argument in detail.

Overall inflation scenario is perhaps the worst after inflation targeting was adopted

India’s inflation targeting framework first came into effect for the period from August 2016 to March 2021. Under the new agreement between RBI and the government, the central bank was expected to maintain the benchmark inflation rate as measured by the Consumer Price Index (CPI) at 4% within a band of +/- 2%. The central bank would have failed in its mandate if inflation stayed outside this target for three consecutive quarters. The arrangement was renewed for another five years in 2021.

A simple look at retail and wholesale inflation measures suggests that the inflation scenario is the most challenging at the moment since the inflation targeting framework was adopted. While the benchmark inflation rate stayed above the 6% mark for four consecutive quarters beginning March 2020, there is some ground to argue that price pressures were not as broad-based then. The Wholesale Price Index (WPI), which is the best available proxy for producer prices was still showing a low growth rate.

To be sure, the disruption in supply chains on account of the pandemic – India imposed one of the most stringent lockdowns in the world which went on for 68 days beginning March 25, 2020 – must have generated tailwinds for inflation which MPC could not have foreseen.

The inflation situation now is quite different. WPI is at its highest ever levels and CPI has once again surged above the upper limit of RBI’s tolerance band in the March 2022 quarter. Most experts, MPC included, see inflation rising going forward.

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A lot of the domestic price pressure is on account of global factors

To be sure, the recent surge in inflation is not on account of typical overheating (an economy growing beyond its growth potential) in the economy which is what the traditional inflation targeting framework seeks to address. Inflation has emerged as a major problem in the entire world, including the advanced countries which were the most successful in controlling inflation in the past few decades. International commodity price pressures can be clearly seen from the World Bank Pink Sheet data which gives indices of various kinds of commodities. These price pressures are expected to generate tailwinds for price levels in India. On the other hand, the fundamental premise of a rate hike purging excess demand and hence taking care of inflation, is more difficult to materialise when faced with a global inflationary upsurge from the supply side.

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Monetary tightening comes at a time when credit demand is still tepid

While the evidence on rate cuts helping the cause of growth in India is patchy in the recent past – GDP growth rates kept falling despite rate cuts in the pre-pandemic period – it is a fact that lower interest rates did encourage a lot of producers and consumers to take more loans. With rate hikes leading to an increase in debt servicing costs, including on mortgages, some amount of demand squeeze is bound to happen. When seen in the larger backdrop of the fact that credit demand growth is still significantly below its historical levels, this is an even bigger reason for concern.

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But monetary policy normalisation had to begin sooner rather than later

While RBI’s unscheduled announcement has come as a shock to many, there was a widespread consensus over the fact that the central bank was about to expedite the process of normalisation of the post-pandemic easy money policy. While any increase in interest rates is an increase on the cost side of households and businesses, it is also a fact that the real interest rate (nominal rate after adjusting for inflation) continues to be negative in India. It is perhaps this fact which has is reflected in the MPC resolution terming the monetary policy stance as accommodative even after a rate hike.

Not only are negative interests rates a drain on the incomes of those who live on savings, persisting with such policy driven easy money policy can also lead to misallocation of scarce capital in any economy, especially towards speculative activities.

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Growth prospects still remain uncertain

The tone of the April resolution of MPC and its May 4 decision, when compared to earlier post-pandemic resolutions, clearly shows a shift in policy priorities. While MPC’s earlier resolutions were categorical about doing all it will take to revive growth, of late there has been a growing concern about the inflationary threat to the economy even at a time when demand continues to be low. “The MPC expects inflation to rule at elevated levels, warranting resolute and calibrated steps to anchor inflation expectations and contain second round effects,” the May 4 resolution of the MPC said.

“We agree with RBI that today’s move will strengthen medium-term growth. Our work clearly shows that high inflation is detrimental to growth,” HSBC chief India economist Pranjul Bhandari said in a research note issued on May 4. The larger consensus on the centrality of controlling inflation notwithstanding, the extent of inflationary contribution to near-term headwinds to growth remains uncertain with possible upside risks.

For example, India’s services PMI reached 57.9 in April, up from 53.6 in March. “The seasonally adjusted S&P Global India Services PMI Business Activity Index highlighted a sharp rate of expansion that was the fastest since last November”, the press release said. However, business confidence went down despite such a sharp improvement in PMI. “Inflation concerns restricted business confidence in April. Although still positive overall, the overall level of sentiment slipped from March and was much lower than its long-run average,” the PMI release said.

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