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Friday, January 15, 2021

Inflation got back into the target zone

by Ajay Shah.

On 20 February 2015, MOF and RBI signed the `Monetary Policy Framework Agreement', and the power of monetary policy (i.e. setting the short term rate) got connected to an objective (get y-o-y CPI inflation to 4%, with a permissible range from 2 to 6 per cent). For some time thereafter, it worked rather well.

From late 2019, we have had problems with inflation. In December 2019, the bound was breached, when inflation reached 7.36 per cent. In the 12 months from December 2019 to November 2020, there was only 1 month (March 2020) where the value at 5.84 was within the 2-to-6 range.

There was considerable angst about this. For many people, aggregate demand was clearly adversely affected by social distancing, and the task of monetary policy was to stimulate demand. In this period, headline inflation being above 6 per cent was an irritant. It even proved, to some, that the very concept of inflation targeting was flawed. There was the angst that is often heard in India, about supply constraints that shape inflation.

RBI eased monetary policy using the many instruments that it possesses, including the repo / reverse repo rates where the votes of 3 external members of the MPC also count.

In my research network, we felt comfortable about this stance of monetary policy:

  • Our models, which work with seasonally adjusted data, suggested that headline inflation would drop in December. 
  • We expected that the easing of supply restrictions that comes with post-pandemic normalisation would help address glitches in the price system.
  • Our macroeconomic common sense suggested that at a time of weak aggregate demand, inflationary pressure was going to be low. 
  •  In any case, monetary policy acts with a long delay. Headline inflation (a moving average of the point-on-point inflation of the latest 12 months) is a poor guide for anticipating headline inflation about one to two years out.

These arguments fed into our writings of this period: 7 Apr, 24 Jul, 24 Aug, 4 Dec, 11 Jan (the day before the December CPI release). 

We now have a data release for December 2020 and headline inflation was reported at 4.59 per cent, which is close to the target of 4 per cent, and well below the upper bound of the target range, of 6 per cent:

Headline inflation, in the inflation targeting period

I am reminded of Ken Rogoff who once said "Those who think inflation is caused by too little pork rather than too much money are wrong" (in the Financial Times, 4 February 2008). It speaks well for the Indian economic policy process, that the Ministry of Finance and RBI stayed the course through this period, and protected the inflation targeting system.

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