On inflation, RBI has been behind the curve

In large part, this shift in the MPC’s views is a result of the ongoing Russia-Ukraine conflict. The sharp rise in commodity prices, especially that of crude oil, will have a significant bearing on inflation. However, to say that this conflict alone is responsible for elevated inflation, and warrants a recalibration of monetary policy, will be inaccurate. Unlike other economies, inflation in India was elevated even before the pandemic and has remained so. Retail inflation stood at 6.3 per cent in the second half of 2019-20, 6.2 per cent in 2020-21 and 5.5 per cent in 2021-22. And it bears repeating — the inflation target is 4 per cent, not 5 per cent or 6 per cent.

In February, just before the beginning of hostilities, the RBI had projected inflation to trend lower at 4.5 per cent in 2022-23. This inflation forecast, as in the past, provided the MPC with the justification to continue with its, by and large, accommodative policy stance. However, even though the sharp surge in commodity prices in the weeks thereafter was difficult to predict, the central bank’s assessment of inflation and as a consequence, the stance of the committee, was considered to be off the mark even at that time. Inflationary pressures had already begun building in the economy. And considering the long lags, strong policy action was warranted.
But, this was not the first time that the RBI’s inflation projections have been off the mark. In fact, in recent times, inflation has often been higher than the central bank’s expectations.

Let’s rewind the clock. In the initial years after the transition to the inflation targeting regime, actual inflation was largely in line with the RBI’s inflation forecasts. In fact, for most of the period between October 2016 and the first half of 2019, actual inflation outcomes were below the central bank’s projections. Inflation averaged 4.5 per cent in 2016-17, 3.6 per cent in 2017-18, 3.4 per cent in 2018-19, and 3.2 per cent in the first half of 2019-20. And this was a period marked by demonetisation, the shift to GST, the implementation of the 7th pay commission, and other events — all of which had raised the level of uncertainty in the economy.

Thereafter, the precision with which the RBI has forecast inflation — a vital input in determining the stance of the monetary policy — appears to have deteriorated quite sharply. The central bank went from overestimating inflation to underestimating it in quite a short span. While it is true that the pandemic injected a great deal of uncertainty into the economy, making projections of both inflation and growth difficult, more so in the initial period, the forecasting errors began before that. Beginning in the second half of 2019, inflation consistently overshot the central bank’s projections. Mere correlation or causation?

In the initial months of the pandemic, even as there was considerable uncertainty over the trajectories of both growth and inflation, the commentary from the RBI suggested that it believed inflation would soften considerably in the second half of 2020-21. Inflation, however, remained elevated. The scenario thereafter has hardly been any different with inflation remaining above the central bank’s target for around two-thirds of the period.

This year, in its February policy review, the RBI projected inflation at 5.7 per cent for the fourth quarter of 2021-22. But actual inflation turned out to be 6.34 per cent. In April, the central bank revised its earlier forecast, raising it to 6.3 per cent in the first quarter of 2022-23, trending downwards thereafter to 5.8 per cent in the second quarter. However, considering the current trends in prices, the incomplete pass-through of higher crude oil prices, and the possibility of another round of telecom tariff hikes, it is increasingly likely that the central bank continues to underestimate the inflationary pressures in the economy. In fact, it is quite probable that inflation breaches the upper threshold of the inflation-targeting framework for three consecutive quarters this year as well. For an inflation-targeting central bank, consistent forecasting errors of such magnitude can mean only one thing — it stays behind the curve.

To be fair, inflation is now a global problem. But other central banks have been far more sure-footed in their response. For instance, the US Fed officials have openly spoken about multiple rate hikes. In comparison, the MPC minutes do not provide any indication on the extent of tightening that it may be contemplating, and over what time frame, to bring inflation in line with its target. Considering that the more delayed the policy action is, the greater will be the adjustment that is required — and closer it will be to the next general elections when political considerations will perhaps dominate — far greater clarity is called for.

Lastly, the MPC minutes also raise questions over whether the external members of the committee are basing their decisions on their own expectations of the trajectory of inflation or that of the central bank. Considering the magnitude of the forecasting errors, and concerns of groupthink, this requires clarity. Thus, to ensure transparency and provide greater clarity, the committee members should publicly disclose their individual projections of inflation and interest rates.

ishan.bakshi@expressindia.com