India’s Consumer Price Inflation (CPI) rose to a 6-month high of 6.3% in May-2021. For the first time since November-2020 inflation is above the upper band of 6% set for the Monetary Policy Committee (MPC). More importantly, the Core inflation rose to above 6.5%, the highest in more than 3-years.
This spike in inflation ought to, under normal circumstances, result in a recalibration of the monetary policy. Except that we are not in normal circumstances. We are in a pandemic situation where growth is highly depressed and there are all kinds of disruptions/dislocations happening in the economy – the movement of labour, movement of goods, operation of factories, access to consumers etc. So, the question is whether monetary policy should see a recalibration given the spike in inflation or should the status quo continue?
But, before we get into it, a brief digression into the current Monetary Policy regime is warranted. It will help set matters in context. India moved to a regime of inflation targeting in 2016. But we moved to what is called a flexible inflation targeting regime rather than hard or fixed inflation targeting regime. What this means is that while Inflation control is the primary objective before the RBI/MPC, they also have a supplemental objective in supporting growth. Thus, the preamble to the RBI Act, now reads as follows:
“…the primary objective of the monetary policy is to maintain price stability while keeping in mind the objective of growth.”
This has been operationalised in practice through a range or band for inflation. While the inflation target is 4%, the MPC has a range of 2ppt around that. So, the MPC has failed in achieving the inflation target only if inflation goes outside this range – below 2% or above 6%. And this has been further liberalised – the MPC is deemed to have failed in achieving its inflation target ONLY if inflation is outside the range for three consecutive quarters.
So, the MPC now has the following flexibility: if inflation is above 6% then the MPC has three quarters within which to get it back to below 6%. And if it does not manage to do so, then the RBI Governor must write a letter to the Central Government explaining why inflation has remained high and what steps they are taking to bring it down and the period in which he expects inflation to reach the target. And if inflation is above 4% but below 6%, the MPC has the flexibility in deciding the pace at which inflation is to be modulated towards 4%.
Thus, let us say inflation averaged 5.9% for 5 years. On a post facto basis this would be a significant dilution of the 4% target set for the MPC. But, if inflation has not averaged above 6% for three consecutive quarters, there is no ‘failure’ on the part of MPC in strictly technical terms. The inflation-targeting framework in India is not just flexible but very flexible. And it is so by design. And even this very flexible framework is an improvement over the framework that existed before – because there was no explicit framework before this!
And this brings us to the current not-normal circumstance. Given how depressed growth is, the MPC has used this flexibility to effectively flip the framework around – Growth is now the primary objective, inflation the secondary. Consider the following unanimous statement from the latest Monetary Policy Statement (from the June policy, emphasis mine):
“The MPC also decided to continue with the accommodative stance as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target going forward.”
Put simply, the MPC is saying that unless and until economic growth revives and on a durable basis (so not just 1-2 quarters), interest rates will remain low – at the close to historic lows that they are currently, and the accommodative stance means they could even go lower if needed. And the only constraint the MPC has imposed on itself is that inflation must remain within the target – which at the upper end is 6%. So, the MPC has effectively, for now, shifted the 4% inflation target to 6%. Whether this is the right thing for the MPC to be doing is not the point of this piece. This is what the MPC has decided it will do and it is a unanimous decision on their part.
To be sure, this statement was issued before the May inflation data which showed inflation has risen above 6%. So, the question is: does the above 6% reading for May change anything? And the answer is, NO, it does not change anything. For one, it is just 1 month’s data. And the average inflation for April and May is well below 6%. Even if inflation were to rise another 100bps in June to over 7%, the average for the Apr-Jun quarter will still be below 6%. More importantly, in the last month, there has been no material change in the growth outlook – the primary objective before the MPC now.
Indeed, it is conceivable that the MPC risks missing achieving even the 6% target (by delaying policy normalisation) if economic growth does not evolve as per its trajectory in the next few months. And if this does happen, it will find a government that is receptive, rather than critical, of its actions.
And there are legitimate reasons to not over-interpret the May inflation data. For one, the country was in the midst of a severe second wave of Covid. Lockdowns of varying intensity had been imposed across large parts of the country. This had severely disrupted the movement of goods as well as people. Prices arising during this period may not be a fair approximation of what the price level would be when the Covid wanes. Specifically, in May, the CSO could collect 2/3rds of price quotations whereas, in January and February 2021, it had collected quotations for 90% of items. While 67% of observations is still large, the decline is unlikely to be evenly distributed across all items. Quite possible that several items saw less than 50% of price quotations. And most of this would be from the discretionary or core inflation basket. And this reduces the confidence one can place on this data.
As the second wave ebbs and lockdowns get lifted, the business activity would return to some semblance of normalcy. Some of the price hikes taken during May might get rolled back and some might stick. Equally, some of the price cuts taken during May might also be rolled back while some others might sustain. The price level in July or August is probably a better marker of what the underlying inflation is than the price level in May, in the middle of the significant disruptions. And we believe the MPC recognises this.
So, the bottom line is that the MPC is unlikely to get perturbed by the May inflation number. Its resolution post the June meeting suggests that, at least for now, inflation has become irrelevant unless it is expected to sustain above 6%. And even then, unless growth starts recovering durably, inflation might remain irrelevant. Inflation targeting has been effectively suspended for now. The central bank, rightly or wrongly, is for now at least a growth targeting one. Interest rates will start to trend up IF growth starts to track above MPC’s trajectory.