RBI Stubborn Rate Stance Seems Like Adolescent Naysaying Given Current CPI Reality

The September print of inflation numbers should focus attention on the Reserve Bank of India’s (RBI) consistent misreading of price signals for some time now. A week before the retail numbers were out, the RBI under Governor Urjit Patel raised its second-half inflation forecast to 4.2-4.6 per cent, but the Consumer Price Index (CPI) inflation rate was flat at 3.28 per cent while wholesale inflation actually fell to 2.6 per cent.

Earlier, in August, we saw a sharp spike in inflation, both retail and wholesale. While CPI rose from 2.36 per cent in July to 3.28 per cent in August, the Wholesale Prices Index (WPI) rose from 1.88 per cent to 3.24 per cent. While both CPI and WPI are still well below 4 per cent – the mid-point that the RBI has to target over the medium term – what should cause real worry is this question: if price movements can be so jerky and sharp month-on-month, will we ever get a sensible monetary policy?

Consider what has happened in August. The spike was caused entirely by food and fuel, with the food price index component of the WPI rising 5.75 per cent, and this too was narrowly driven by a 44.91 per cent zoom in veggies, and 88.46 per cent in onion. As for fuel, the index shot up by 10 per cent, largely due sharp increases in petrol and diesel pump prices.

In short, the sharp boost in WPI and CPI was the result of one or two items, neither of which can be controlled by monetary policy. While it is fair to say that if spikes in food or fuel result in generalised inflationary expectations, monetary policy cannot sit tight. But what if these price increases are seasonal, and restricted to one or two items, both of which are amenable to executive decisions on imports or exports, duties or tax cuts? For example, it is entirely possible to moderate the fuel price increase by cutting taxes, just as a rise in, say, onion can be met through quick imports.

In September, the fall in retail and wholesale inflation was driven largely by food, and in October one may still see fuel price inflation impacted by the cut in excise duties on petrol and diesel by centre and some states.

So what role should monetary policy be playing in non-core inflation areas like food and fuel? And does inflation targeting of overall retail inflation make sense, when the impact of RBI policy is restricted to those segments where monetary action impacts directly?

The one gain post-demonetisation is that more money has now become part of the formal financial sector, both as bank deposits, and as investments in mutual funds. This means monetary policy will actually become more effective with the growing formalisation of the economy, including through the expansion of the tax base with the implementation of the goods and services tax (GST).

In this scenario, monetary policy – now decided by six wise people in the Monetary Policy Committee rather than just the RBI Governor – can be made more relevant by focusing on core inflation and the formal sector, rather than giving it a wider ambit of tracking retail inflation in general. Right now, given the huge role government plays in deciding the final prices of food, fuel and power, from the stage of procurement pricing to subsidies on inputs and taxation, what the RBI does has practically no impact on inflation in these segments of the index.

So, if the RBI delays interest rate cuts because onion prices have brought tears to consumers or fuel prices are burning holes in the pockets of middle class car or bike owners, it would be a travesty given that growth is now clearly the bigger challenge. While food and fuel price inflation may be transitory, holding the larger and struggling manufacturing sector hostage for this reason is foolish.

In any event, fiscal policy has figured out ways to undercut monetary policy even in the limited area of interest rates by offering subventions, whether it is for agricultural credit or exports or affordable housing.

The only way we can make both monetary and fiscal policy effective is by reducing the focus on inflation-targeting to what the RBI can reasonably control, and leaving the task of controlling other prices to the executive, which anyway is accountable to the people. At some point, when most prices in the economy are market-determined, we can review the ambit of inflation-targeting again, but right now, when government directly impacts prices in food and fuel, which have a collective weight of 28 per cent in the WPI and 62 per cent in the CPI, monetary policy needs to be more sharply focused on core inflation.

In the Indian context, the western model of keeping monetary and fiscal policies in separate buckets makes no sense. Monetary policy cannot be targeted only on inflation, and fiscal policy only on growth and jobs. Both have to work in tandem to meet objectives in all three areas – at least at this stage in our growth story.

Thanks to the heavy criticism of the RBI during demonetisation, it is trying to assert its independence by playing deaf on pleas for lower interest rates. This looks more like adolescent naysaying than real policy-making. The case for a rate cut is stronger than ever.

(A part of this article was first written for DB Post)