The article analyses the challenge faced by the Monetary Policy Committee in wake of a pandemic where falling growth is accompanied by the rising inflation.

Dilemma with inflation targetting in pandemic

• After the RBI’s adoption of a flexible inflation targeting framework from August 2020, it became even more focused on anchoring inflation and inflation expectations than ever before.
• But the COVID pandemic has created a dilemma for the RBI.
• Higher-than-anticipated inflation compelled the monetary policy committee (MPC) to hold policy rates despite the contraction in April-June GDP by 23.9 per cent.

 CPI vs. WPI: Which should be focused for inflation targeting?

• Inflation-targeting framework based on one narrow nominal consumer price index (CPI)  has highlighted the challenges of conducting monetary policy in a severe growth shock scenario.
• Inflation targeting is particularly challenging if it coincides with a sharp increase in headline CPI inflation as in the current period.
• The current framework has led to an excessive and obsessive emphasis on point CPI estimates, at the cost of ignoring other indicators.
• WPI core inflation, which essentially represents the manufacturing sector, is below 1 per cent but this does not find much mention.
• This is strange because ultimately, the GDP deflator is calculated using both CPI and WPI inflation, with the latter having a greater weight.
• This should be taken into consideration, while reviewing the existing monetary policy framework.
• Given the composition of the current CPI basket, RBI’s monetary policy actions can at best impact only 41.35 per cent of the overall items.
• Food and beverages, fuel items, gold and silver tobacco/intoxicants are items over which the RBI does not have any control.[58.65 per cent of the overall items]

This is a different time

• In normal times, a sustained increase in food and fuel prices can lead to a generalised increase in prices.
• But this argument is not valid in the current context where a large number of people have lost their jobs or have seen fall in incomes.
• In the current context, higher food and fuel prices would lead to reduction in expenditure on discretionary items.
• So there will be only a relative shift in prices, without any fear of a generalised spiral, as households will not be in any position to demand higher wages to compensate for the increase in prices of food and fuel items.
• Given the amount of slack in the economy, a scenario of sustained generalised increase in prices seems unlikely over the next 6-9 months.

How to measure the success of inflation targeting

• The CPI inflation targeting framework has helped to reduce inflation expectations during FY17-FY21 on average (9.3 per cent) compared to the previous period of FY12- FY16 (12.8 per cent).
• However, the gap between inflation expectations and actual CPI inflation has remained unchanged at 5.1 per cent during these two periods.
• The success of the inflation-targeting framework should not only be judged by the actual CPI inflation trend, but also in terms of gap between the two.

How RBI performed without inflation targeting framework in the past

• Even without any formal inflation-targeting framework, India had successfully managed to keep inflation low during FY02-FY06.
• The RBI’s stance then was based on a multiple-indicator approach to conduct monetary policy.
• First factor that made it possible was the increase in minimum support prices of food-grains was kept below 3 per cent on average.
• Second factor was the composition of growth which was better during this period with investment growth surpassing consumption growth by several percentage points.
• It is for this reason that CPI inflation remained contained at 4 per cent on average during this period even with 7 per cent real GDP growth.

Risk of structural increase in inflation

• In the current cycle, investment growth is likely to be impacted more severely than consumption growth.
• Given the acute weakness in the demand side of the economy, persistent problems in the real estate sector, continued deleveraging of the NBFC sector and significant job losses structural increase in inflation is limited.

What should be the policy response

• The scope for rate cuts remains dim in the near-term.
• But the RBI to remain active with a host of unconventional measures, which will likely include more proactive bond purchases to ensure that market interest rates do not rise significantly due to fiscal and market borrowing-related concerns.

Conclusion

Given the prevailing unholy mix of growth and inflation, it is tempting to categorise India’s economic situation as one of “stagflation”. But, in our view, it is too early to conclude decisively on this matter, given the fluid nature of things.

Back2Basics: Inflation expectations

• Inflation expectations are what people expect future inflation to be, and they matter because these expectations actually affect people’s behavior.
• If people expect inflation to be lower and they act on those beliefs, they could, in fact, cause inflation to be lower.
• If businesses expect lower inflation, they may raise prices at a slower rate; they don’t want the prices of their items to look too out of line with those of their competitors.
• If workers expect lower inflation, they may ask for smaller wage increases.
• The combination of businesses and workers acting in this manner will result in the economy experiencing lower inflation.

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