India’s Inflation Target: Even As RBI Caves In, Monetary Policy Is in Govt Hands

The Central Government had fixed an inflation target of 4% in CPI, with upper and lower tolerance limit of 6% and 2%

It is ironic that the RBI, which has almost no control over CPI inflation, has written a letter offering an explanation for having failed to keep inflation under limits to Central Government, which perhaps is more directly responsible for the CPI inflation.

Image: For Representative Purpose

The Reserve Bank Of India(RBI) is statutorily obligated to target 4% CPI inflation. Containing consumer price inflation to a level as prescribed by the Central Government, in consultation with it, is RBI's statutory responsibility (Section 45ZA of RBI Act) since 2016.

RBI's failure to meet the inflation target requires it to set out the reasons why it hasn't been able to achieve so in a report (Section 45ZN) to the Central Government. In addition, the RBI has to propose remedial actions and provide an estimate of the time period within which the inflation target shall be achieved.

Centre’s New Inflation Target

Exercising its powers, the Central Government in 2016, fixed an inflation target of 4% in terms of Consumer Price Index (CPI), with upper and lower tolerance limit of 6% and 2% respectively. Refixed in 2021, these are currently applicable inflation targets. The Central Government has further prescribed an exceeding inflation target in any three consecutive quarters as the standard of failure.

But it has not prescribed what it would do with the report and what corrective action would be taken if the failure continues.

RBI’s Monetary Agenda

The RBI Act amendment created a Monitory Policy Committee (MPC) to meet six times a year and decide on monetary policy actions. However, the responsibility to maintain inflation in the target range is that of RBI's.

RBI's press release dated 3 November, informed that a separate meeting of the MPC was held "to discuss and draft the report to be sent to the Government’" by the RBI. The meeting was chaired by the Governor of RBI and all the members attended.

What report was drafted and when was the report sent to the Central Government has not been publicly informed.

Impact of Annual Price Rise on Economy

An increase in the rupee prices of goods and services is inflation.

CPI measures inflation in specified consumer goods and services. Inflation in most industrial goods is measured by the Wholesale Price Index (WPI). WPI inflation has been running in an excess of 10% for more than a year now. In May and June 2022, it had crossed more than 16%.

CPI which measures food, fuel, clothing and some services, was 7.41% in September 2022, marking continuous three quarters in excess of the upper tolerance limit of 6%. Economy-wide inflation, combining CPI and WPI, has exceeded by 6% for about 15 months now.

The Government and the RBI ignore economy wide and wholesale inflation. Economists focus on core of CPI. There is no core in CPI, which relates to industrial goods and is housed in WFI. Economists and media also ignore WPI and real core inflation.

Let it be it so. Today, let us focus on consumer inflation as measured by CPI.

RBI’s Instruments To Impact Inflation

Inflation arises only if the effective demand for any goods or services exceeds available supply. The cost of supply and quantum of supply determine the supply-side dynamics of inflation.

Effective demand is based on three fundamental factors—consumers’ income base, transfers from the government and availing of credit by consumers. Inflation is the result of changes in net effect of supply and demand-side dynamics.

RBI is in the business of regulating money and credit supply in the economy and also influences cost of credit. RBI regulates money and credit supply by adjusting liquidity using its instruments (read repo, reverse repo, marginal standing facility, standing deposit facility, and so on). RBI also signals cost of credit by adjusting short-term rates of interest.

RBI, thus, has two instruments—liquidity or quantum of credit supply and cost of credit for influencing inflation.

Inflation dynamics in India

CPI food inflation was 8.41% in September 2022. Food and beverages have 46% weight in CPI. Cereals and cereal products recorded an inflation of 11.53% while vegetables and spices' inflation rose by 18.05% and 16.88% respectively. Clothing inflation at 10.17% and fuel inflation at 10.39% were on the higher side as well.

The proteins did not see much inflation—meat and products 2.55%, eggs 1.79% and edible oils and fats 0.37%. Services (health, transport, education etc.) inflation was much lower at 6.06%

A close look at the supply dynamics of food basket tells very clearly that inflation is mostly explained by weather (wheat crop adversely affected by higher temperatures in Feb-March; spatially poor monsoon affected rice crop and unseasonal October rains affected vegetables), government policy (diversion to ethanol) and international prices (wheat supply disruption caused by Russia-Ukraine war).

Extent of Govt Control on Inflation

Government policy also has had a controlling impact on inflation (restriction imposed on wheat and rice exports). The cost of production of the food is also determined by government policy (minimum support prices, fertiliser subsidies and so on).

The conclusion is inescapable. Supply-side dynamics of the CPI is mostly in government's and god’s hands.

Demand dynamics of CPI goods and services are also quite interesting. The food, clothing, fuel and services are all essential goods and services which makes their consumption demand quite inflexible. The prices of many consumer goods are also determined by the government. Government provides cereals (wheat/rice) to 80 crore people either near zero or totally free. Most of the services (health, education, transport) are either provided by the government or at prices administered/regulated by the government.

Much of the CPI demand dynamics, therefore, is also in government control.

RBI’s Negligible Role in CPI Inflation

RBI’s instruments can, in theory, reduce demand for goods and services by constraining credit supply or making credit costly. However, this works only if the consumption is financed by credit.

Almost entire consumption of goods and services, tracked by CPI, is paid for by the income base and transfers from the government. Very little is credit financed. RBI, therefore, can do pretty little in influencing the consumption demand of CPI basket of goods and services.

Credit does finance purchase of industrial goods e.g. steel and cement for construction of house or purchase of durable consumer goods. The industrial goods, however, are not part of CPI basket.

Interestingly, there is no dent in demand for housing or vehicles loans despite RBI raising interest rates by about 200 basis points in the last six months and withdrawing liquidity significantly. On the contrary, credit growth is the highest in many years, touching 20% last month.

This quandary is perhaps explained by the fact that only about 2% of India’s population generates demands for these loans. This segment wants better houses and better transport. Their incomes are not adversely affected by the pandemic and they have no problems in demanding and servicing these loans.

What RBI’s Report to Govt Signals

As noted above, consumer price inflation is not in the hands of RBI. It is the government, which to a great extent, has the ability to influence this inflation.

It is ironic, therefore, that the RBI, which has almost no control over CPI inflation, has written a letter offering explanation for having failed to keep inflation under limits to Central Government, which perhaps is more directly responsible for the CPI inflation. The Government has taken many measures but obviously, these have not been adequate in the circumstances.

It will, therefore, be no surprise if RBI offers routine explanation for the failure, promises to do some more monetary tightening, and, arguing that monetary policy acts with a lag, hopes and asks for a time of 6 months or so to bring down inflation in the corridor.

The government will, without any question, accept this formal explanation and wait for prices to cool in its due course. Incidentally, it has failed on the FRBM front, breaching the fiscal deficit target of 3% for the second year running, for which no one has offered any explanation.

This is no good merit in keeping the façade of inflation-targeting regime entrusting RBI with responsibility for controlling CPI inflation and holding it accountable for something which it cannot control.

The government may better junk this flawed and toothless inflation-targeting regime.

(The author is an economy, finance and fiscal policy strategist and former Finance and Economic Affairs Secretary, Government of India. This is an opinion piece and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for the same.)