RBI continues to target GDP growth instead of inflation

Inflation is the rate at which the general price level increases between one time period to another. So if the price level — captured by an index such as the Consumer Price Index (basically a basket of goods) — goes up by 10% in April this year over what it was in April last year, the inflation rate is 10%.

Sometimes, prices fall over the past year. In such a case, we call it deflation. It is like negative inflation.

But this is a rare occurrence.

What mostly happens is inflation — that is a rise in prices. However, sometimes the inflation rate itself may slow down. Suppose prices increase by 10% in January (over last January), 5% in February (over last February) and 2% in March (over last March) — that is referred to as disinflation, which signals a decline in the inflation rate.

So the intriguing question last April was: Will the price level in India fall, or rise or rise at a slowing pace or rise at a progressively increasing pace (galloping inflation)?

To be sure, on paper, all the options were possible.

Prices could fall because in a lockdown, the overall demand for goods and services in the economy would collapse. Add to that the effect of people losing jobs, or facing salary cuts, and thus they will demand less of even the most essential items while cutting down all discretionary expenses (such as buying a fancy new phone or going for a vacation).

But prices could have also risen sharply because the lockdown could have completely disrupted the supply chains. Everything from onion to your favourite breakfast cereal to cars to computers could either not be produced or not transported to you because of the lockdown. A sudden crunch in supply could spike prices, especially of food and other essential commodities, notwithstanding the fall in demand.

Whether we had deflation (due to the collapse of demand) or a sharp spiralling of inflation (due to a supply crunch) was not just of academic interest. All of this mattered because India’s central bank, the Reserve Bank of India, is mandated by law to target the inflation rate.

In other words, keeping the rate at which the general price level facing the consumers increases from one year to another is RBI’s main policy goal. And it is noteworthy that governments don’t always help out the RBI in this regard.

For instance, throughout the past 12 months, the central and state governments have been piling on taxes on petroleum products, thus leading to higher retail prices of petrol and diesel. This, in turn, fuelled inflation because transporting goods became that much more costly. The governments (Centre and states) did this in their bid to shore up revenues in a slowing economy and with little regard to how this may affect the RBI’s plans to maintain retail inflation within the band of 2% and 6%.

The latest Monetary Policy Report of the RBI has a neat chart, reproduced below, which shows that, unlike most advanced and emerging economies, India saw prices going out of its central bank’s comfort zone. In this list, only Turkey performed worse than India in containing price rise.

What is the policy significance of this?

India’s growth was decelerating before the onset of the Covid pandemic and as such, right through 2019, the RBI was in the mode to cut interest rates and incentivise economic activity. For the most part, it did not have to worry much about retail inflation at the time. The RBI doubled down on this resolve when the economy got hit by the Covid pandemic in March-end last year.

Right through the past financial year — April 2020 to March 2021 — the RBI kept signalling that it would support growth and in doing so allowed the inflation rate to stay out of its mandated range.

In other words, the RBI accorded primacy to boosting GDP growth instead of meeting its legal requirement of maintaining inflation within the mandated range.

On paper, the argument was that as and when the economy revives, the RBI would revisit its stance and re-start (in a manner of speaking) targeting inflation instead of growth. To be sure, several observers were of the view that the Indian economy had posted a very sharp recovery in the second half of the past financial year — that is from October 2020 to March 2021.

But by the time the RBI’s Monetary Policy Committee met earlier this month — April 5 to 7 — to decide on its policy stance, India was already in the grip of the second Covid wave. The daily new caseload had already crossed the previous high and was well past the 1-lakh mark.

That meant the RBI was back to square one: Yet again in April, Covid had disrupted India’s already iffy growth trajectory and forced the RBI to choose between boosting growth and containing inflation. To be sure, not only did retail inflation continue to be high in March but even the wholesale inflation spiked to over 7%.

Predictably, the RBI stuck to last year’s playbook. As such, even as it revised upwards its inflation forecast for the year, it declared — once again — that it will continue to support growth for as long as required.

Is there a risk in what RBI is doing?

Yes, there is a chance that inflation may spike — the RBI acknowledged it in the policy statement.

“Pump prices of petroleum products have remained high…The impact of high international commodity prices and increased logistics costs are being felt across manufacturing and services. Finally, inflation expectations of urban households one year ahead showed a marginal increase over the three months ahead horizon according to the Reserve Bank’s March 2021 survey,” it stated.

There is one more factor that may contribute to rising inflation later on in the year: Monsoon.

India has had two normal monsoons and the chances of a third normal monsoon are pretty slim. According to a Crisil report, “in the past 20 years, only once has the Indian economy seen three good monsoon years in a row”. A bad monsoon could spike food inflation, which contributes the most to retail inflation.

If the surge in Covid numbers continues as predicted by experts such as Bhramar Mukherjee (Professor of Epidemiology at the University of Michigan), India could be hitting a daily caseload of up to 10 lakhs (or 1 million) by the middle of May, with deaths peaking with a lag of a fortnight to anywhere between 4,500 to 5,500 level.

In other words, India’s economic growth prospects for this year could be significantly dented. Not surprisingly, most forecasters in town have dialled down their GDP growth rate projection for India.

An iffy growth coupled with persistently high inflation could further weaken the Indian currency and, in doing so, make imports such as crude oil and other commodities, even costlier, thus fuelling domestic inflation further.

The simplest solution to all woes of the Indian economy lies in vaccinating as fast as possible while saving the lives of those who are critically ill.