India’s MPC  Runs The Risk Of Failing The Three-Strikes Rule
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India’s MPC Runs The Risk Of Failing The Three-Strikes Rule

The Indian economy is likely to see its first contraction in over four decades this year. That should depress demand and bring down inflation sharply, leaving space for monetary policy to act. That’s been the broad economic narrative against the backdrop of the Covid-19 crisis.

Except the data is not supporting the narrative yet.

Inflation has remained high. A mix of supply disruptions, one-offs such as higher gold prices, along with volatility in prices of some food items are being blamed for the confusingly high inflation.

Should the trend continue, the Indian central bank may miss its inflation target for three quarters in a row—the trigger laid down in the amended RBI Act as the point at which it would need to explain its failure to meet the inflation target.

The higher inflation reading raises the spectre of average inflation in Q3 following the footsteps of the Q2 average of 6.5%, marking the third consecutive quarter of inflation breaching the RBI’s upper threshold (which could technically trigger the need to write a letter, although this is not certain given the break in the series in April and May).   
Sonal Varma, Chief India Economist, Nomura

What The RBI Act Says

The MPC—India’s first—has been handed a target of maintaining retail inflation at 4%, with a tolerance band of +/-2% around that target.

The central bank would be seen as failing to meet the targets if retail inflation remains above 6% or below 2% for three consecutive quarters. If this were to happen, the RBI Act says, the regulator shall submit a report to the central government listing:

  • The reasons for failure to achieve the inflation target;
  • Remedial actions proposed to be taken by the Bank;
  • An estimate of the time-period within which the inflation target shall be achieved pursuant to timely implementation of proposed remedial actions.
The Monetary Policy Committee’s term ends on a rather somber note as inflation technically has ended up above the target band for last three quarters, but we are in extraordinary circumstances. With consumer prices staying elevated in July, inflation is set to breach the RBI’s tolerance band for three straight quarters, warranting the MPC to write an explanation to the government detailing reasons for the miss and propose remedial actions to bring the price levels back within the tolerance zone.
Rahul Bajoria, Chief India Economist, Barclays

Why Inflation Has Been High Despite Weak Growth?

The Indian economy was slowing even before the Covid-19 crisis hit. Despite the weaker growth, inflation remained sticky for a variety of reasons.

In the January-March period, headline inflation was driven by food items, such as onions where prices surged due to unseasonal rains. Other food items such as milk and pulses, among others also saw higher prices.

The April-June quarter saw an entirely different set of factors at play. As the country went into lockdown, data collection was disrupted and the government released only imputed inflation data. The MPC, over these months, did not give its own inflation forecasts. In addition to concerns over data quality, sudden supply disruptions have impacted prices. Equally, higher taxes imposed on petroleum products to help support government revenues pushed up inflation. A surge in gold prices globally also impacted the ‘personal effects’ consumption category, which includes gold jewelry.

In its August resolution, the MPC said that it is of the view that the CPI prints for April and May can be regarded as a break in the CPI series. It, however, said it is conscious of its mandate. “The MPC is conscious that its primary mandate is to achieve the medium-term target for CPI inflation of 4% within a band of +/- 2%. It also recognises that the headline CPI prints of April-May, 2020 require more clarity,” the resolution said.

Inflation is expected to remain elevated in the course of the July-September quarter. The major reason that inflation has risen is because of supply side disruptions which monetary policy can’t control. Had the rise been because of a surge in demand, it would be construed as a failure of monetary policy.
Devendra Pant, Chief Economist, India Ratings & Research

Madan Sabnavis, chief economist at CARE Ratings shared that view. “It is not as if the spike in inflation is because of monetary expansion, said Sabnavis, adding that the economy is faced with unusual circumstances.

In the months to come, Sabnavis sees conflicting inflation trends. “While food prices are expected to ease, core items may see higher prices as services turn costlier temporarily. There is also a chance that the target may not breached as food prices might subside after the agricultural harvest,” he said.

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