Managing inflation: RBI's MPC has faced external challenges since inception

The Reserve Bank of India (RBI) Act, 1934, was amended in 2016 to introduce a flexible inflation targeting (FIT) framework in the country. This was a momentous occasion in the history of India’s monetary policy, as it marked the beginning of monetary policy decisions being made by a six-member monetary policy committee (MPC), consisting of three internal and three external members.

Until then, the governor of the RBI had the sole power to take monetary policy decisions. Although the RBI had constituted a Technical Advisory Committee (TAC) in July 2005, it lacked statutory backing. The MPC was constituted in line with trends observed in other major central banks, which had adopted a committee approach to monetary policy decisions. However, unlike the Federal Reserve System in the United States (US) or the European Central Bank in the euro area, where decisions are reached collegially, the MPC in India (as in the United Kingdom) reaches decisions individualistically, i.e., through voting, with each member having one vote. However, in the case of a tie, the governor has a second or casting vote.

The MPC has been mandated to achieve an inflation target (measured in terms of consumer price index) of 4 per cent, with a tolerance band of +/-2 per cent. The inflation target is fixed once every five years. How has the MPC fared in achieving this target? Before addressing this question, it needs to be noted that a 4 per cent inflation target does not mean that inflation can be held at the target rate all the time. If any exogenous shock causes headline inflation to deviate from the target, the MPC needs to bring the inflation rate back to the target gradually over time. Any attempt to bring the elevated inflation rate back to the target swiftly will require the MPC to raise the policy rate sharply, which could severely impact growth and create uncertainty in financial markets. Thus, the inflation target is required to be achieved over the medium term, allowing the MPC to balance inflation control with growth concerns. This flexibility is embedded within the tolerance band.

Since October 2016, consumer price index (CPI) headline inflation has averaged 5 per cent, against the target of 4 per cent. In 67 out of 94 months, headline CPI inflation was above the target. Also, the headline inflation was above the upper tolerance level of 6 per cent for three consecutive quarters, from January-March 2022 to July-September 2022. Under the RBI Act, if the average inflation exceeds the upper tolerance level of 6 per cent or falls below the lower tolerance level of 2 per cent for any three consecutive quarters, it is considered a failure to meet the inflation target. In such cases, the central bank needs to set out in a report to the central government (i) the reasons for failing to achieve the inflation target, (ii) the remedial actions the RBI intends to take, and (iii) an estimate of the time frame within which the inflation target will be achieved. Accordingly, the RBI was reported to have submitted a report to the central government in this regard in November 2022.

However, the inflation record during the FIT framework needs to be put in perspective. Prior to the adoption of the FIT framework, headline CPI inflation averaged 7.3 per cent over nearly five years (January 2012 - September 2016). During this period, headline inflation reached 10 per cent or more in 8 out of 57 months and exceeded 9 per cent in 20 months, peaking at 11.5 per cent in November 2013.  In contrast, under the FIT framework, headline inflation reached 7 per cent or more in 10 out of 94 months, with a peak inflation of 7.8 per cent in April 2022.

Thus, the inflation rate under the FIT framework was significantly lower than during the five-year period preceding it. This reflected better anchoring of inflation expectations of households, which moderated to 7.9-11.9 per cent and 8.3-11.5 per cent for the three-month and one-year ahead periods, respectively, under the FIT regime, compared with 8.8-12.8 per cent and 9.3-13.5 per cent, respectively, in the previous five-year period.

Furthermore, it is significant that the last eight years have been marked by some extraordinary events, especially the Covid-19 pandemic in 2020-21 and the ongoing Russia-Ukraine war, which began in February 2022. While the Covid-pandemic seriously disrupted the global supply chains, the Russia-Ukraine war sent the prices of global commodity prices, especially oil, soaring. Central banks the world over were taken by surprise with a sudden surge in global inflation, reaching multi-decade high in major advanced economies.

For instance, inflation rose to 9.1 per cent in the US, 11.1 per cent in the UK (a 40-year high in both countries), and an all-time high of 10.6 per cent in the euro area, well above the target of 2 per cent. It is significant that inflation has remained above the target for 42 consecutive months in the US, and 38 months each in the UK and the euro area, though inflation in these economies is now on a downward path and gradually approaching the target.

In sum, CPI inflation in India remained above the 4 per cent target during most of the period under the FIT framework, caused mainly by severe multiple supply shocks. However, inflation expectations in India remained reasonably well-anchored, leading to a lower overall CPI inflation rate compared to the preceding five years. Nevertheless, it is important to ensure that headline inflation is aligned with the target, which will further enhance the credibility of the FIT framework. 

The writer is senior fellow, Centre for Social and Economic Progress, New Delhi, and a former executive director of RBI