Caution on inflation

RBI's primary mandate should remain inflation targeting

The Reserve Bank of India (RBI) last week released the minutes of the meeting of the Monetary Policy Committee (MPC), conducted earlier this month. In that meeting, the six-member MPC had left the repo rate unchanged at 4 per cent, while maintaining an accommodative stance. This was a unanimous decision of the six members. The minutes now reveal that the members of the MPC seem to believe that their duty is to support growth recovery from the pandemic. In the minutes, Governor Shaktikanta Das specifically says that “the second wave of the virus has necessitated the continuation of monetary measures to support the process of economic recovery to make it durable”. In fact, Deputy Governor Michael Patra argued that “policy choices have shifted towards increasing accommodation”, and Ashima Goyal said that the output gap had widened, and so policy had to “further stimulate demand”.

The RBI’s subordinate mandate is indeed to support growth. But it should remember that it is now an inflation-targeting central bank. The RBI Act requires the central bank to explain its actions if inflation is out of the tolerance band for three consecutive quarters, and so the MPC is within its legal rights to ignore the fact that consumer price inflation in India is now out of its tolerance band and is running at 6.3 per cent. This is being driven by broad-based core inflation, which is sticky. Wholesale price inflation is also higher than it has been for almost three decades, hitting a record high of 12.94 per cent in May, driven by a continued rise in fuel and commodity prices as well as due to a low base effect. Last year inflation was out of the tolerance zone for two quarters; it then went back below 6 per cent, thanks to a sudden drop in food prices in particular. The fact is that while the RBI might have considerable legal wiggle room, there is no doubt that it appears to be discounting the danger of inflation because of the context of the pandemic. This comes at a time when the government is also running massive fiscal deficits —and many central banks worldwide are beginning to consider how to pause or pare their accommodative stances.

The central bank must remember the dangers of inflation to investment and growth as well as to poverty reduction are the reasons for its primary mandate. If the Indian economy’s fundamentals are sound, as RBI economists have argued, then it will bounce back once the constraints of the pandemic are removed. Instead of keeping the tap flowing, the RBI should, therefore, be prepared to act in advance of a sudden jump in aggregate demand and perhaps anchor higher expectations of inflation among companies and consumers. Unfortunately, this does not appear to be the central bank’s priority at the moment, although its mandate and basic economic logic both suggest it should be. The government is also comfortable with higher inflation in the current circumstances because it allows for heftier dividends to support government spending at a time when other revenues are faltering. This is why independence and a single focus for central banks are valuable. At a time when many other central banks have been cautiously adjusting their approach, India cannot afford sustained accommodative policy to mar the recovery from this pandemic by entrenching inflation in the economy.