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On inflation, how the RBI failed, why it matters

Arvind Subramanian, Josh Felman write: Central bank has been behind the inflation curve, its mistake was never corrected or even challenged. It's a failure of the institution and its guardrails.

Arvind Subramanian, Josh Felman write: There is little virtue in independence that creates ongoing conflict. Indeed, under some previous RBI regimes, there was perhaps more conflict than necessary or desirable.

Central banks have it easy when inflation is low because then they can provide ample liquidity at low interest rates, pleasing the nation’s borrowers. Their mettle is tested only when inflation rises, requiring them to take unpopular measures. So far, the RBI has been failing this test and that too on its core mandate. Consider how.

Start with the data. The recent upsurge in food and fuel prices has given the impression that India has simply been a victim of global circumstances, a casualty of Russia’s invasion of Ukraine. But India’s inflation problem began long before the war started. As the chart shows, monthly inflation has been above the RBI’s 4 per cent target since October 2019. In other words, for nearly three years the inflation target has been honoured only in the breach. Indeed, for 18 out of 32 months since October 2019 (56 per cent of the time), inflation has even been above the RBI’s ceiling of 6 per cent. Inflation has also become broad-based.

Yet for most of this period, the RBI did not react at all. If the US Fed and the European Central Bank (ECB) have been behind the curve for about a year, the RBI has been further behind, for longer. Even now, it is not leaning hard against inflation, but remains in “accommodative” mode, reflected in the striking fact that real policy rates are negative (minus 2-3 per cent) so late into a high inflation episode.

How could this have happened when this government has enshrined an inflation targeting regime into law to ensure the RBI keeps inflation under control? One simple answer is that the RBI made a mistake. It misdiagnosed the situation, repeatedly ascribing the problem to temporary factors, even as its own “core” measure showed that underlying inflation was consistently running around 6 per cent.

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But this only begs the deeper question of why this mistake was never corrected or even challenged. After all, the inflation targeting regime has a host of safeguards to check monetary mistakes. The RBI has a mandate to keep inflation at 4 per cent; its forecasts and policy stance are reviewed and approved by a Monetary Policy Committee (MPC), and the central bank must give a public accounting if inflation exceeds 6 per cent for three consecutive quarters. Yet somehow all three institutional guardrails have failed. Let us count the ways.

To begin with, the RBI’s mandate was ignored. The central bank was given one major task, curbing inflation, with the secondary objective of promoting growth as long as inflation remained under control. But the RBI acted as if it had three additional objectives: One, it tried to temper the decline in the rupee, selling a large portion of its foreign exchange reserves (“exchange rate targeting”). Two, it tried to keep interest rates on government securities low, purchasing large amounts of g-secs to help the government finance its fiscal deficits (“fiscal dominance”). Three, it tried to pay ample dividends to the government (“fiscal dominance with an Indian twist”).

The last point bears elaboration. Most analysts assume that the RBI’s dividend depends on factors beyond its control. But this is not entirely true. For example, when the RBI sells foreign exchange, it can declare a profit on the valuation gain. When it sells, say, $10 billion at an exchange rate of Rs 78/dollar, it can declare a profit of Rs 8,000 crore if the dollars were bought at Rs 70/dollar. V Ananth Narayan has argued that without these profits the RBI would have been unable to pay a dividend at all last year.

Consumer Price Inflation from October 2019 to May 2022.

With the RBI chasing five, yes five, different targets (inflation, growth, interest rate, exchange rate, and dividends), it is hardly surprising that it lost sight of its inflation objective. Indeed, as inflation began to rise, the central bank began to act as if its target was actually 6 per cent, as T N Ninan has pointed out. Somehow, ceilings turned into floors, until even these “floors” were breached for long periods.

At the same time, the MPC also failed. The MPC has three outside members, precisely to provide independent technical analysis and counsel. But the published minutes suggest they have not produced alternative inflation forecasts. Nor have they seriously challenged the monetary strategy. As Rajeswari Sengupta has emphasised, decisions in the recent past have tended to be unanimous.

Furthermore, after inflation continually exceeded 6 per cent in 2020, the RBI should have issued a public report, explaining how it was going to bring inflation back to 4 per cent. But it did not do so, citing statistical problems. Yet hardly anyone complained, not even in the analyst community.


Why did the guardrails fail so comprehensively? At one level the answer is clear: The RBI and the MPC felt impelled to help the government by pursuing objectives such as controlling g-sec rates and paying large dividends, and possibly also preventing any perceived loss of confidence in government policies by supporting the rupee. But whether they did so because the government applied pressure on them or whether they were second-guessing the government’s objectives will never be known.

Regardless, the failure truly matters for several reasons. High inflation has many costs but a particularly serious one is that it is a tax on the poor. Workers in the informal sector, unlike their formal sector counterparts, will not receive automatic wage increases. Nor will they receive significant ad hoc increases because small-scale producers don’t have sufficient funds to do so, especially after the shocks of demonetisation, GST and Covid. Consequently, workers’ real wages will fall and they will be forced to consume less.

That is why politicians used to fear the electoral consequences of high inflation. Whether and why that dynamic has changed — including the role of better safety nets in cushioning some of the consequences — is worthy of serious study. But no matter; the economic consequences certainly remain.

Another reason why these failures matter is that they raise worrisome questions about institutional integrity and competence. Institutional independence, to be sure, does not mean that institutions cannot work cooperatively with the government in power. There is little virtue in independence that creates ongoing conflict. Indeed, under some previous RBI regimes, there was perhaps more conflict than necessary or desirable.

But now the pendulum has swung in the other direction, jeopardising independence and integrity. Institutions — especially those as important and as deservedly respected as the RBI — cannot become mere extensions of the government.


Perhaps most important, the failure of the guardrails matters because inflation control is the lynchpin of macroeconomic stability which, in turn, is the foundation for sustained, inclusive growth. For nearly three years, monetary policy has been careening off course, while the RBI has risked becoming another casualty in the broader erosion of Indian institutions. The consequences could be serious. They probably already are.

Subramanian is former chief economic adviser to the government, and Felman is former IMF resident representative to India.

First published on: 14-06-2022 at 07:15:01 pm
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