Lessons from RBI’s attempt at inflation targeting

The RBI broke its vow, although unintentionally. With the July retail inflation touching 7%, the central bank missed its inflation mandate for four months in a row. It appears certain that the breach will extend to three consecutive quarters and when it happens, Governor Shaktikanta Das will be forced into a humble public submission to the Parliament. Consumer prices already crashed the RBI’s upper tolerance band of 6% in the past two quarters.

We may have two months left in Q3, but the July figure tells us that the final print won’t be pretty. Plus, Das warned us just last week that we were staring at the barrel of a gun as for as future price rise was concerned. Usually when inflation becomes a problem-child, all central banks have to do is cut rates. But that’s not an option we have as the repo rate is anchored at 4% and anything lower will see sharper negative real rates.

Policymakers aren’t putting on blinkers either and instead are overlooking the spike caused solely due to supply constraints driven by labour shortage. Much of the increase is led by food prices, which refuse to remain within the realm, agonising both policymakers and households. It imposes real costs on the economy and erodes the value of money. Still, Das hopes prices must dis-inflate on their own for two reasons:  the RBI has little control and monetary policy simply has no effect on inflation when the economy is supply-constrained. 

Incidentally, the steep rise comes just when the RBI’s inflation-setting Monetary Policy Committee’s term ends this month. The question is whether India’s first attempt at inflation targeting worked. As it is, policy watchers echo the gripe about the RBI’s error-prone inflation forecasts and that core inflation should be 
the nominal anchor besides widening the target band itself by 1-2%. Moreover, the inflation index looks imbalanced with excessive services components, the consumption of which fell dramatically during Covid-19. Even if we shrug off the record high inflation as a little bad data, some of these adjustments are essential for posterity.