Central banking conundrum

RBI should not continue to ignore inflation risks

US Federal Reserve Chairman Jerome Powell has told lawmakers that inflation has been higher and a bit more persistent than expected. While Mr Powell continues to maintain that higher inflation is transitory and prices will ease in the coming months, the rate-setting body of the Fed has in its last meeting adjusted its interest rate projection. The inflation rate was at 5.4 per cent in June. Most large central banks intervened heavily in 2020 to contain the impact of Covid-induced disruption in the economy. Although economic activity is now recovering, central banks do not want to make the mistake of withdrawing the support too early which can affect the recovery process. Economic recovery in the US has been much stronger than expected and is putting pressure on prices.

However, the Fed is not the only central bank dealing with a higher inflation dilemma. The problem in India is even more complicated because the inflation rate has gone above the tolerance band of the Reserve Bank of India (RBI) despite a slower than expected pace of recovery. The inflation rate based on the consumer price index (CPI) in June remained above the 6 per cent mark for a second consecutive month. Core inflation has also been above 6 per cent. The wholesale price index-based inflation rate is in excess of 12 per cent. Notably, CPI-based inflation is high despite a higher base of last year, and is expected to remain elevated in the coming months. It is worth noting that notwithstanding the expectation of a good monsoon, the sowing of kharif crops has dropped significantly which can affect output and prices. For instance, compared to last year, acreage for some variety of pulses has declined by over 20 per cent. With persistent pressure from other components, higher food prices may not allow the inflation rate to come down in the near term.

This can make sustaining the current policy position of the Indian central bank increasingly more difficult. The RBI maintains that inflation is being driven by supply shocks because of disruption related to the pandemic along with increase in margin and taxes. Although there are still significant risks to economic recovery, the RBI needs to revisit its stance on the inflation situation. A number of central banks, such as those in Russia, Turkey, and Brazil, have raised interest rates. This is not to suggest that the RBI should also increase rates, but it must explain to what extent it is willing to tolerate higher inflation. Had the RBI not treated April and May 2020 as a break in the CPI series, it would have failed to achieve the inflation target. The rate was above the upper end of the tolerance band for over three consecutive quarters. 

Sustained higher inflation will affect the credibility of the central bank and push up inflation expectations. In any case, the target is 4 per cent, not 6 per cent — the upper end of the tolerance band — as the central bank seems to have interpreted. It is understandable that the central bank is focused on reviving growth and has taken a number of steps in this regard since the outbreak of the pandemic, but it must also now start deliberating how it will stop inflation from getting more generalised. Ignoring higher inflation for too long can increase medium-term economic risks.