Monetary policy dilemma

Persistent inflation challenges foundations of policy framework

That inflation is coming down is apparent in both the Consumer Price Index (CPI) and the Wholesale Price Index (WPI), for both of which the February 2014 numbers were published last week. CPI inflation was down from 8.8 per cent in January to 8.1 per cent in February. WPI inflation was down from 5.1 per cent in January to 4.7 per cent in February. In its previous avatar, the Reserve Bank of India (RBI) would presumably have read the latter number as inflation having entered the comfort zone, paving the way for the interest rate cycle to start moving downwards. In its current version, with the CPI having been nominated as the inflation benchmark, while eight per cent is still outside the upper tolerance limit of six per cent, it has indicated its preference for a gradual movement towards that range. It sees eight per cent as an acceptable level over the coming year. In fact, RBI Governor Raghuram Rajan had gone so far as to say that he did not expect any more rate increases after having raised the repo rate by 25 basis points in the January review. The CPI numbers support that prognosis.

However, inflation-watchers are now getting used to the idea that month-to-month variations in inflation rates are significantly influenced by vegetable prices. Virtually the entire softening over the past few months is on this account. Core inflation measures, which strip the more volatile components - food and energy - from the calculations, actually do not paint all that rosy a picture. Core CPI inflation has been particularly stubborn at eight per cent or over, showing virtually no sensitivity to monetary policy actions. WPI inflation for manufactured products, although relatively subdued overall, has shown a distinct pickup over the past three months. The former pattern, in particular, must cause some concern to the RBI. It is understandable if food inflation shows no particular sensitivity to interest rates, given that it is being driven by supply side forces in the short term. However, core inflation is another matter. The entire foundation of the current monetary policy framework is that policy actions influence inflation expectations. A tight policy stance should persuade workers and producers to rein in their planned wage and price increases, thus contributing to lower inflation.

This pattern was visible in core WPI inflation, which fell sharply over the past few quarters, but now appears to have bottomed out. But, the obduracy of core CPI inflation really challenges the foundations of the framework itself. If even core inflation is not being impacted by the monetary policy stance, as would appear to be the case, two questions need to be asked. First, what exactly are inflationary expectations being driven by, that would make the impact of monetary policy on them marginal at best? Second, if expectations are not being influenced by monetary actions, what is needed to be done differently to re-establish control? More aggressive tightening? This would go against Governor Rajan's reassurance that rates had peaked out. A 180-degree swing to reviving growth? This would make businesspersons and investors very happy, but would turn the policy framework on its head. Until this dilemma is resolved, the RBI is at risk of being trapped in a halfway house.