Why lockdown can save the RBI from explaining ‘failure’ to fight inflation to govt

RBI has to answer to Parliament if it misses the inflation target for three quarters. Inflation has stayed above 6% for two quarters now, with a third likely.

The Reserve Bank of India (RBI) logo | Vivek Prakash | Bloomberg

Mumbai: It seems the Covid-19 lockdown may have allowed the Reserve Bank of India (RBI) to wriggle out of an embarrassing situation.

The central bank is currently facing the grim prospect of answering to Parliament for failing to achieve its inflation target.

According to the RBI Act, if average inflation stays out of the 2-6 per cent range for three consecutive quarters, then it is seen as a failure of the central bank. Average inflation was above 6 per cent in the March and June quarters, and also over 6 per cent in July and August.

However, if minutes of the monetary policy committee (MPC) meeting after the August policy review are an indication, the central bank may have found a way of not writing an explanation letter to the government.

The MPC is of the view that there was a break in the consumer price index (CPI) series since inflation data for April and May was imputed and not collected by visiting the markets by NSO surveyors. The surveyors could not make the field visits for data collection due to the nationwide lockdown imposed to curb the spread of novel coronavirus.

“The NSO has adopted best practices in producing these imputations for the purpose of business continuity in the face of challenges to data collection due to the nation-wide lockdown. The NSO has, however, not provided inflation rates for April and May,” the MPC observed in the August meeting minutes.

“For the purpose of monetary formulation and conduct, therefore, the MPC is of the view that CPI prints for April and May can be regarded as a break in the CPI series.”

Put simply, the MPC has come to the conclusion that there is a break in the CPI series since there was no data collection in April and May, and the inflation figures for these two months was the estimation of NSO and not the actual numbers.

‘Valid point, but explain’

Experts agree with the MPC that there is a break in the CPI series, but say the central bank should still write the letter to the lawmakers explaining the same.

“The point that has been made by RBI that the series is broken is technically right,” said A. Prasanna, head of Research, ICICI Securities PD.

“Since prices of many items were not available, the index was imputed in April and May. So that is a valid point. But my own view is, that itself can be mentioned in the letter. They can explain this in the letter and then give their outlook. RBI’s outlook is that inflation will come down in the second half without any policy action,” Prasanna told ThePrint.

In its submission to the lawmakers for failing to achieve the inflation target, the central bank needs to answer three questions — why it has failed to achieve its target; what remedial measures it would take to bring inflation back within the target range; and by what time.

In the minutes, RBI indicated remedial action to bring back inflation will be hiking interest rates.

“…if inflation persists above the upper tolerance band for one more quarter, monetary policy will be constrained by mandate to undertake remedial action, including an immediate and more than proportionate response to head off the build-up of inflation pressures and prevent it from getting generalised. The question is: can the economy withstand it in this virus-ravaged, debilitated state?” RBI Deputy Governor Michael Patra said in the minutes.

So, if CPI series is seen as broken, then interest rate hikes can be avoided.

‘Media and markets creating a big issue’

But why would there be a need for remedial measures as RBI’s own estimates suggest inflation will come down in the second half of the financial year?

“We track September inflation at a lower 6.5%, albeit still above the RBI’s 2-6% mandate. That said, we see CPI inflation slipping to 2.5-3% in 2HFY21 on the back of base effects, good rains and low demand with FY21 GDP set to fall 7.5%,” BofA Securities said in a note to its clients.

It expects the RBI to cut interest rates by 15 basis points in the next policy review meeting scheduled on 1 October and a total 75 bps in the current financial year. In this financial year so far, the RBI has reduced the policy rates by 40 bps.

“So I don’t agree with the point in RBI minutes that they will have to spell out remedial measures. RBI can say that without any monetary action inflation will subside below 6% by next year. So where is the need to take remedial measures,” Prasanna said.

He said the media and markets have created a big issue out of writing a letter, which is a very mechanical and a procedural thing, in his view.

“…it should not be called a failure if inflation exceeds target due to one off factors. This word failure has created a stigma. For example, the Bank of England also wrote those letters in 2010 when inflation rose above their target. Notably, they were doing quantitative easing at that time. But they wrote a letter explaining why inflation was high and why it will come down without any need for policy action,” he added.