Tuesday, November 1, 2022

Inflation blues. Is MPC responsible for inflation? Business Line 2nd November 2022

 The announcement of an MPC meeting to be held on November 3 had a shock effect. This waned, on the realisation that the agenda was not interest rates but the explanation to be given to the government on inflation control.

When the MPC was constituted in 2016 the task was to frame policy such that inflation remained within a band of 2-6 per cent with 4 per cent being the anchor. If there were breaches for three quarters in a row, then it would be interpreted as ‘failure to achieve the inflation target’. As CPI inflation has been above this mark for this period, an explanation is called for under the amended RBI Act.

The RBI has to provide an answer in three parts. First, it has to explain why inflation has been high. Second, it has to state its actions on controlling inflation and the way forward. Lastly it has to give timelines for bringing inflation back within the band. Answering the first two questions are relatively easier, while the third could be tricky.

Confidential reply

While RBI’s reply will be confidential, there is market speculation over its contents. Prices have risen sharply in FY22 which continued in FY23 due to the resurgence in global demand, which pushed up commodity prices. Prices went up further after the Ukraine crisis , and started cooling down from July. The strengthening of the dollar added to imported inflation.

Given the lower base of 2020-21 when the world slipped into negative growth, inflation has been high. Now high commodity prices have caused companies to transmit their input costs this year and hence inflation has become more broad-based.

The services sector has come back into operations post April and increased prices to make up for both input costs as well as business foregone during the lockdowns.

Prices of agricultural products like edible oils and pulses increased too due to shortages, while wheat joined the pack when the war broke out and farmers preferred selling in the export market as supplies from Russia and Ukraine were cut off.

The RBI to combat inflation increased the repo rate by 190 bps over the last four months with more hikes likely. This is in sync with what other central banks are doing.

Ideally an explanation should go jointly from the RBI and government as there have been instances of GST or trade taxes being increased, which have added to inflation. Similarly, high oil prices which are not accompanied by States cutting VAT add to inflation in a dual manner — cost of oil as well as ad valorem taxes. Quite clearly the RBI has an answer here too on the way forward.

The third part is the time taken to restore a balance in inflation. With prices already cooling at the global level, the base effect would automatically make the inflation numbers return to the trajectory of 5-6 per cent in 2023 and the central bank’s forecasts on inflation which are provided in the credit policy will serve as the roadmap.

Food, oil volatility

But oil and food price movements are the big uncertainties going ahead.

The government could get a glimpse of the MPC members’ thinking if it reads the monetary policy minutes.

The minutes provide the members’ perspectives at every meeting which will throw light on how the decisions evolve. But more likely, the explanation would probably be a formality since there is a logical explanation for all the three queries that need to be addressed.

At the broader level two questions arise. The first is whether central banks or the monetary policy committee can be held responsible for inflation given that it is a global phenomenon thanks to supply shocks. In the West, inflation was triggered by fiscal pumping which increased demand across all goods and services.

Similarly high crude oil prices cannot be controlled by raising the Fed rate or the repo rate, but needs fiscal action. Interestingly, other central banks are not accountable to their governments for not meeting inflation targets.

The second is the 4 per cent number for inflation. Admittedly, this number was reviewed and accepted for the second time when the MPC’s first term came to an end. But is this number fair? If we look at the CPI inflation number for the last 10 years, it was higher than 4 per cent in eight of them while in five years it was greater than 5 per cent.

Therefore having a base of 4 per cent looks too optimistic to be taken as a benchmark. There may be a case for reviewing this number.

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