Should RBI have written a letter to Government for missing the inflation targets?

In the December-2020 Policy, RBI kept the policy rates unchanged. In the statement, central bank raised inflation expectations for the upcoming quarters and noted that said elevated inflation “constrains monetary policy at the current juncture from using the space available to act in support of growth”.

In the post-policy meeting with the media, Mythili Bhushurmath of ET Now asked following question from the RBI Top Management:

You have listed six objectives, Governor- enhance liquidity, deepen financial markets, conserve capital, strengthen supervision, facilitate external trade, upgrade payment system. Nowhere there is a mention of getting inflation under control at a time when inflation is running well above our upper band of 6%, and for close to three quarters. In fact, this is the time when RBI perhaps should be presenting a statement in the Parliament, on what it has done to inflation. So, would I be wrong in assuming that somehow de-facto inflation targeting, at least as we knew it, has been junked?

This is interesting and I have been thinking about this for a while.

In October 2016, RBI adopted the policy of Flexible Inflation Targeting (FIT) under which it was given an inflation target of 4% with a band of +/-2%.

More importantly, the Government put onus on RBI for failing to achieve the inflation target.  The Govt defined the failure as (click on The goal(s) of monetary policy) inflation being higher than the upper band of the target (6%) or lesser than the lower band (2%) for three consecutive quarters.

In case of failure, three things are to be done:

• RBI will be required to send a report to the Central Government stating the reasons for failure,
• The remedial actions and
• The time-frame under which the inflation will be brought back to the target.

Since adoption of FIT, inflation has been within the band for most months. In the period Oct-2016 to Oct-2017, inflation was below the target of 4%, then moved higher than 4% till July-2018 and again dipped lower than 4% till September-2019. From December-2019, inflation has not just risen but has been higher than the upper band. The average inflation in the period Dec-2019 and Oct-20 has been 6.85%. More importantly, inflation has been above 6% for all the eleven months barring one month of Mar-2020, which recorded inflation of 5.84%.

This raises the question: shouldn’t RBI have written a letter to the Government explaining its failure to as envisaged in the law?  RBI’s answer to this would be that is simply following the Act. The Act says if inflation is higher than 6% for three consecutive quarters, then RBI has to write a letter to the Government. But this has not been the case as March-20 numbers were marginally lower than 6% which means the cycle was broken.

However, as we can see March inflation numbers were almost equal to 6%. This case raises several issues with our FIT policy. RBI is to review its FIT framework in 2021 and could look at these issues.

First, the failure to not able to meet the target over three consecutive quarters is an extreme. Bank of England is supposed to write a letter when they miss the target of 2% by +/-1% each time which is also extreme. A shorter period is needed for RBI.

Second, the need to clearly specify what will be deemed as failure to achieve the target. Currently, the law implies that if RBI fails to achieve monthly inflation below 6% (and above 2%) for three consecutive quarters, it will be deemed as failure. But what if all the months barring one show failure? That too a mumber like 5.84% which is closer to 6% and not 5%. Wouldn’t this be deemed as failure as well? If the Government instead changes the law to “average inflation in three quarters” then some sharp jumps (or sharp declines) in a couple of months will be deemed as failure.  How to address this problem?

Third, can monetary policy affect inflation in India given much of it is driven by food prices?  We can divide the inflation in three sources: food, fuel and other items such as housing, transportation etc., also called as core inflation. In Dec-19 and Oct-20, average inflation in food has been 9.5%, fuel has been 3% and core items has been 4.85%. Thus, much of the inflation has been driven due to food prices. The weight of food prices in inflation basket is 45.8% which in turn has pushed overall inflation upwards.  In the words of Milton Friedman, “inflation is always and everywhere a monetary phenomenon”. This implies inflation is always due to easier monetary policy and RBI should tighten the policy by raising interest rates. The critiques of Friedman’s approach will respond saying monetary policy cannot address food inflation and this is the job of government. India actually needs an even easier policy to support ailing economy.

Fourth, connected point is another old debate of whether RBI should target the headline or core inflation. Headline inflation comprises the entire basket and core inflation excludes the food and fuel components. Currently, RBI targets the headline inflation which automatically means it has to look at food prices. Few economists have argued that RBI should instead target the core inflation where food and fuel prices do not come into the equation. Ironically, whichever way we look at, food prices do influence both headline and core inflation. The average core inflation has started rising and has been 5.4% since Apr-20. Food remains a major component and eventually influences expectations leading to broad-based rise which reflects in core inflation as well.

The above analysis leads to the famous saying: “the more things change the more they remain the same.” Despite a modern inflation targeting framework some of the old questions remain unaddressed and are making a comeback. The inflation has remained above the upper band for 11 months now. While the Act allows RBI to not explain its failure to keep inflation low to the Government, should it not explain the same to people?