From UPSC perspective, the following things are important :
Prelims level : WPI and CPI
Mains level : Paper 3- Inflation challenge
Despite being legally mandated to keep inflation in check, RBI has persisted with easy monetary policy, even as inflationary pressures have increased. We need to understand why, and what could be the repercussions.
Inflation problem in India
- For most of the past two years, CPI (consumer price index) inflation has been hovering close to the 6 per cent upper threshold of the RBI’s target band.
- Inflation averaged 6.1 per cent during the pandemic period (April 2020 to June 2021), despite a massive collapse in aggregate demand.
- Then in January 2022, as food prices recovered, headline inflation once again crossed the upper threshold of the inflation targeting band.
- Inflationary pressures do not seem to be diminishing either. Instead, they continue to build up.
- The standard measure of inflation “in the pipeline” is WPI (wholesale price index) inflation, since price increases at the wholesale level tend to translate into retail inflation in due course.
- Russia’s invasion of Ukraine has resulted in a sharp increase in global commodity prices, including prices of crude oil, edible oils, and fertilisers.
- Indian firms are already adapting to this situation, passing on commodity price increase to retail prices.
Issues with RBI’s stance
- Standard economics gives us a guide for how central banks should react in a situation like this.
- Two conditions: It says that monetary policy should accommodate the first round of commodity price increase, but only under certain conditions, notably that inflation is initially on target, and expectations are firmly anchored.
- But neither condition holds at present. Inflation is already too high, and so are expectations.
- An argument is nonetheless being made that monetary policy should not be tightened when inflation is driven by supply-side factors, as it can adversely impact growth.
- This is fallacious. When there are supply constraints, using easy monetary policy to boost demand is not going to boost output.
- And if firms are expecting high inflation, this will send things into a vicious spiral, as they will increase their prices even more in advance of any input price pressures.
- Surely the RBI is aware of all of this. So why is it still not acting on it?
Why RBI is ignoring inflationary pressure?
- Growth concerns: The problem seems to be that governments all over the world are worried about growth.
- The US Federal Reserve has been slow to raise rates even as inflation has reached a four-decade high. The European Central Bank has been even slower to react.
- Fiscal dominance in India: In India, monetary policy also suffers from a strong fiscal dominance.
- As a result, not only is the RBI expected to support growth, it is also expected to keep the government’s borrowing costs in check, which is in direct conflict with its inflation targeting objective.
Implications of RBI ignoring inflationary pressure
- Aggressive reduction in interest rates: A decade ago, we were in a similar situation when RBI delayed its response because it was focusing on growth.
- When inflation subsequently took off, it reached double digits and the RBI had to raise interest rates aggressively to bring it down.
- That was a very painful adjustment.
- Impact on credibility of the RBI: In addition, if the RBI does allow inflation to take off, there will be long-lasting repercussions for its credibility.
- Unachrored expectation: if the public sees the RBI consistently ignoring inflation, expectations can rapidly get unanchored, and then it becomes very costly to bring it down.
To conclude, inflation is best addressed by the central bank using monetary policy, not by the government adjusting taxes. The RBI needs to urgently revisit its inflation forecast and its monetary policy stance in order to avoid potentially painful adjustments down the road.