How Long Can RBI ‘Look Through’ Pandemic-Time Inflation?

We are coming up to the eight-year anniversary of the Urjit Patel Committee report on revision and strengthening of the monetary policy framework, which led to India adopting the ‘flexible inflation-targeting’ or FIT framework in spirit, and later from 2016 as the explicit target for the conduct of monetary policy. By and large, it has been a success.

Consumer Price Index inflation has retreated from 9.6% in 2010-2013 to 4.9% from 2014-2021. In fact, since April 2014, there have been only 24 months in which the inflation target of 2% to 6% has been breached. While India had several breaches in 2014 itself when the framework was adopted in practice, the majority of these target misses have come during the pandemic years of 2020 and 2021. Given the extraneous circumstances of supply shocks, we believe the outcome still broadly underpins the credibility of the framework and the important role it has played in providing macroeconomic stability.

Still, India’s inflation shifted to a higher gear in the course of the pandemic. But there appears to be a willingness on part of the Reserve Bank of India and the government to ‘look through’ these inflationary shocks to some extent.

Does the data over a longer curve suggest that the RBI has allowed inflation to stay higher in the pandemic years? Breaking the eight years since the Patel Committee report into two halves, the experience of the first four years (2014-2017) and the second set of four years (2018-2021) show broadly similar inflation, averaging around 4.9% in both periods. The last four years have been marked by greater volatility inflation prints, as low CPI of 2018-2019 balanced out the rise in inflation during the pandemic period. That 4.9% average is also very near the unofficial CPI inflation target of 5% India had before it adopted the FIT framework, and also appears to be somewhat of an anchoring point for the RBI, at present.

It is also worth emphasising that some increase in inflation on the back of the pandemic is to be expected. Indeed, the causality between the emergence of the Black Death pandemic in Europe and higher labour costs and inflation as far back as the 14th century has been well established. India’s inflation during the 1918 Spanish Flu pandemic was also close to all-time highs even as GDP contracted by a record 10.5% on account of the unprecedented supply shock.

While India’s economic structure has changed dramatically in the last 100 years, the emergence of high inflation on account of supply bottlenecks initially, and then imported prices should not be a surprise. Still, as we are starting to piece together an economic recovery from the ravages of the pandemic, what is RBI’s current view about inflationary risks? The market certainly has been indicating that the RBI may need to reverse its accommodative policy and raise rates aggressively.

We believe there are three considerations at play for the RBI, despite the relatively elevated path of inflation that it is looking at in the next 12 months.

First, India’s inflation in 2021 appears to have been driven by imported products, in contrast to 2020 when domestic supply shocks and the disruption of value chains were instrumental. While this is more visibly obvious in the WPI inflation, the CPI, given its focus on domestic services and higher weight of food, is less moved. The directly-imported components of the CPI, just above 10% of the basket—comprising motor fuel, cooking gas, edible oils, and gold among others— account for almost half of the inflation India has experienced in the last six months, which is around 2.4 percentage points out of 5.1% headline CPI. The other around 90% of the basket has contributed the other 2.7 percentage points.

Second, the trajectory of the domestic sources of inflation, especially food, is not necessarily worrying. While food inflation will likely rise in the coming months, the underlying impulses around food prices are not particularly strong. Barring 2018-19, food prices in India have been trending lower, and India’s food inflation volatility has declined over the last decade. This is especially true for non-perishable items, where with the significant exception of edible oils, India has by and large achieved self-sufficiency for key product groups like cereals, pulses, sugar, dairy, and spices. Even for perishable items such as vegetables and fruits, the average inflation in the last five years has been 3.8% and 3.6% respectively, which is below the headline inflation registered in the same period and in line with food inflation, which has averaged 3.9% in the last five years.

The third key reason for the RBI’s reticence on inflation appears to be a revealed preference and ability to tolerate higher inflation for some time. As we established earlier, India’s average inflation since adopting the flexible inflation targeting framework has been closer to 5% than 4%. This complements the approach of the governor and the MPC to focus on the inflation target band of 2-6%, rather than its mid-point target of 4%, which is broadly in line with the average inflation India has experienced in the recent past, supply shocks notwithstanding.

Beyond these issues, there is a need to debate what the terminal real rate in post-pandemic India might be. It is clear that the RBI feels that India’s output gap is unlikely to close for several years, which will warrant the central bank maintaining reasonably accommodative conditions for some time.

In such an environment, the question posed by the presently-high inflation will be whether or not to keep real rates negative or close to zero for an extended period, even when economic recovery appears to be well in sight. This is also precisely the point that is causing some divergence within the MPC, with one external member arguing that holding the repo rate at 4% is consistent with the economic backdrop, but the level of negative real rates (currently benchmarked off the reverse repo) is not. But at least for now, the RBI and its leadership has signaled, both in verbal guidance and MPC meetings that the current level of policy accommodation remains broadly appropriate.

We expect the central bank to be largely comfortable with the inflation rate being anchored within the 4-6% band, with the average being closer to 5% over 3-4 quarters.

If this plays out, we believe the RBI would continue to lag the global monetary policy cycle and do not see any material reason for the central bank to raise rates aggressively.

We expect the policy rates to end the year around 4.50%, which will just be a resetting of the real rates from highly negative, to only slightly negative, given the pace of the economic recovery.

Rahul Bajoria is Managing Director, and Chief Economist – India, for Barclays.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.