Govt should have made RBI's 2022 inflation failure report public: Janak Raj

We are still in the early stages of reaping the full benefits of FIT. It is, therefore, imperative to remain focused on the primary objective, he said

Janak Raj, former executive director of the Reserve Bank of India (RBI) and a former internal member of the central bank’s Monetary Policy  Committee, says — in an email interview with Subrata Panda — that if the weighting of food in the consumption basket is expected to decline further as income levels rise, that could provide ground to consider a lower target for the headline inflation rate. Edited excerpts: 

 Has inflation targeting fundamentally changed the price dynamics of the Indian economy, or has it improved the monetary policy’s credibility and communication? 

Both are related and reinforce each other. There is enough evidence to suggest that the inflation dynamics in India have changed through anchoring inflation expectations better, and that can be attributed to inflation targeting. India is prone to frequent supply shocks from food and fuel, which always carry the risk of second-round effects. Therefore, it is critical that expectations remain anchored. I am not saying expectations have become well anchored. But they have become better anchored than before. And that helps mitigate second-round effects and achieve better outcomes. This, in turn, has improved credibility.  

However, we still have a long way to go. We are in the early stages of reaping the full benefits of flexible inflation targeting (FIT). It is, therefore, imperative to remain focused on the primary objective. This may entail somewhat greater output volatility in the near term, but that is a price worth paying — it will help improve the tradeoff and deliver a lower variability of both output and inflation over time when the central bank can be more flexible.

 

After a decade, is 4 per cent still the right (inflation) number for India?  

The target was based on parameters laid down in the Urjit Patel Committee report. However, the retail-inflation rate (the headline rate) during the FIT period (up to August 2025, when the review of the inflation target was taken up) averaged close to 4.8 per cent, and even the core-inflation rate close to 4.9 per cent. The inflation rate was 8.7 per cent during the period June 2008 to September 2016 (a similar period prior to the FIT), though this was an unusual period of high food inflation and not strictly comparable. 

However, the consumer-price rate was 4.9 per cent even during the period January 2002 to May 2008. Even the RBI’s discussion paper indicated that trend-inflation rate lay between 4.1 per cent and 4.4 per cent. Therefore, going by the empirical record — a trend rate of 4.1-4.4 per cent and a realised average rate of 4.8 per cent — one could have made a case for an inflation target above 4 per cent, say, 4.5 or 5 per cent.  

However, having set the target at 4 per cent, raising it was fraught with risks. Any attempt to do so would have sent the signal, a wrong one, to economic agents that the RBI was weakening its resolve to maintain a low rate. This might have unhinged inflation expectations and made the task of achieving any higher inflation target as challenging as achieving the 4 per cent target now. Therefore, it is important to create conditions to align the inflation rate with the target to enhance the effectiveness and credibility of FIT.  

Anyway, there was no case to lower the inflation target below 4 per cent then. The next review will be due in March 2031. If the MPC is able to align the realised inflation rate with the target on a durable basis by then, a case could be made to somewhat lower the target. This is not out of the realm of possibility.  

Significantly, the Ministry of Statistics and Programme Implementation (Mospi) has indicated that it will conduct the Household Consumption Expenditure Survey (HCES) more frequently — every three years. If the CPI series can also be revised every three years, the weighting of food is expected to decline further in the consumption basket as income levels rise. This could then provide ground to consider a lower target for headline inflation.

 

One of FIT’s claimed strengths is its flexibility. How much inflation should the MPC be willing to reckon with when the shock comes from food, energy or geopolitics? 

FIT essentially means the central bank is required to bring inflation back to the target over the medium term, not immediately. The idea is to ensure that the economy does not suffer undue output loss or forgo growth due to any unexpected shock. However, flexibility comes at the cost of greater inflation volatility. Hence, there is a tradeoff between flexibility and credibility. It is significant that unlike some countries where the medium term has been defined as two years, in many central banks, including in India, the timeframe within which the inflation rate is required to be brought back to the target has not been defined. This gives the RBI the flexibility to reckon with transitory supply shocks, but it also places a greater onus on communication to keep expectations anchored as to when the rate will return to target. Therefore, the challenge for any central bank, while exercising greater flexibility, is to ensure that it does not dent its credibility.  

It is hard to define in precise terms how far flexibility should go. This depends on the nature, magnitude and persistence of the shock. A more serious shock such as the pandemic may require greater flexibility. A central bank’s ability to glide over a supply shock, therefore, depends largely on its nature and how inflation expectations are anchored. If the shock is transitory and expectations are well anchored, the bank can afford to be flexible without being unnecessarily worried about second-round effects through a wage-price spiral. However, if a shock becomes persistent and inflation expectations are not well anchored, it spills over into core inflation, or triggers a wage-price spiral, and the central bank must act swiftly to prevent second-round effects from becoming entrenched. At that stage, policy flexibility must end. It is crucial to gauge the nature of a supply shock clearly to avoid any policy missteps.

 

Has the MPC’s experience over the past decade changed how the RBI should think about the distinction between the headline inflation rate and underlying inflation? 

The mandate of the RBI is in terms of the headline inflation rate. No doubt, the core inflation rate, which excludes volatile food and fuel, is more amenable to monetary policy. However, there are three solid reasons for targeting the headline inflation rate. 

First, it captures the cost of living of a typical household. Targeting inflation without food and fuel — with a combined weighting of about 53 per cent in the old series and about 42 per cent even in the new 2024 base (36.8 per cent food & beverages alone) — is meaningless and poses a huge communication challenge. Second, it is simple to understand and easy to communicate.  

Third, persistently high prices of food and fuel can spill over to generalised inflation through a wage-price spiral and second-round effects as expectations de-anchor.  

Therefore, the headline-inflation rate should be at the centre of monetary-policy action and communication. When the statutory mandate itself is in terms of headline inflation, it is not clear to me how to place greater emphasis on the core. In fact, the weighting of food has come down in the consumer price inflation basket, which should now provide greater manoeuvrability to the RBI. The core-inflation rate serves as a useful operational guide in inflation forecasting. The only recent change is that the RBI now publishes forecasts for both the core and headline inflation rates. While many central banks follow this practice, introducing multiple metrics carries the risk of creating some confusion about the RBI’s primary target.

 

The pandemic showed that the monetary policy can face an extraordinary growth shock and an inflation shock almost simultaneously. Does the MPC need a more explicit reaction function for situations where inflation and growth move in opposite directions? 

A pandemic-like situation is indeed extremely challenging because inflation and growth can move in opposite directions in a way that is much more pronounced than a regular supply shock. Whether the MPC needs a more explicit reaction function for such situations essentially hinges on the flexibility available to deal with such shocks.  

The current FIT framework provides enough flexibility. There is a large tolerance band of +/- 2 per cent. To my knowledge, no other major emerging economy has as wide a tolerance band as we have, as alluded to earlier. On top of it, the RBI has further flexibility. It is required to send a report to the government only if the headline inflation rate remains above 6 per cent or below 2 per cent for three consecutive quarters. Even beyond this, it has the flexibility to decide the timeframe within which the rate has to be brought back to the target. However, we need to keep in mind two things.  

First, there is a tradeoff between flexibility and credibility. And for this reason, clear and effective communication becomes the key in such a situation. If the RBI feels that it needs more time to bring the rate back to the target, it needs to be clearly communicated to the public.  

In its report to the government, the RBI, among others, is required to indicate the timeframe within which it will bring inflation back to the target once it has breached the tolerance band.  

The failure to achieve the target has occurred only once — when the inflation rate remained above 6 per cent for three consecutive quarters in 2022 — and a report to this effect was sent to the government in November 2022. However, this report was not made public by the government. Ideally, the report should have been immediately made public. Even now it can be done. The report may not be of much significance now, but transparency demands that it be made public.