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RBI’s report to GoI on crossing inflation target: Here’s an imagined draft.

Date: 31-10-2022
Subject: RBI’s report to GoI on crossing inflation target: Here’s an imagined draft
a​It [the letter] is a privileged communication between the Reserve Bank and the government... From our side, we will not make it public.' With that RBI governor Shaktikanta Das squashed any hope that we may hear the inside story of why the central bank and the Monetary Policy Committee (MPC) failed to read the warning signals. So, we are free to second-guess the contents of the letter, even as the MPC meets later this week to discuss just that.

Remember, the rationale of mandating such a letter is not only to fix accountability, but also, more importantly, to enable RBI and MPC to do some honest, if brutal, soul-searching. Only then will it serve its purpose, as a guide to future governors and MPCs. With that in mind, here's my draft of the letter Das should write - but is unlikely to.

It is with a heavy heart that I sit down to write this letter as mandated under Section 45ZN of the RBI Act, in terms of which the governor is required to write to the government in the event of failure to stay within the inflation target band of 2-6 % for three consecutive quarters.

In truth, I should have written this back in 2020, when inflation exceeded the upper end of the target range for three consecutive quarters. But you were kind enough to allow us some leeway on the grounds that inflation numbers during Covid could not be relied upon. Fortunately, the MPC's external members did not put too fine a point upon it and the public was also willing to give us the benefit of doubt, so we were able to buy time.

We had then hoped we would be able to tread the fine line between supporting growth and keeping prices under control in the coming months, even though the signs on the price front were already ominous and many observers urged us to roll back our accommodative policies. But like the US Fed and other central banks, we believed high inflation would be a temporary phenomenon, driven by supply-side factors.

Unfortunately, we have been proved wrong. The reality is monetary policy works best when inflation is driven by demand, rather than supply-side factors. The result is retail inflation has not only crossed the upper end of the target range for three consecutive quarters but, barring a few odd months, has been high for close to two years now.

It is always difficult to own up to failure, whether individual or collective. But I do hope you will understand our failure is not for want of trying. Nor because we were not sufficiently cognisant of the burden of high inflation on our people, many of whom live below the poverty line and for whom high inflation, especially high food inflation, is the unkindest cut of all.

To give you a quick recap, in the immediate aftermath of the pandemic, RBI embarked on aggressive monetary easing to ensure adequate liquidity, especially for SMEs. We lowered the repo rate and pumped in liquidity in large measure. For months on end, excess liquidity in the system was in the range of ₹6-8 lakh crore. All this bore fruit and I am proud to say India emerged relatively unscathed from the pandemic.

Alas! What we failed to reckon with is that monetary policy acts with long and uncertain lags, and that once inflation expectations get entrenched, it becomes much harder to rein in prices. Both of which explain why core inflation has also been close to 6% for so long now. It also reinforces the view that, perhaps, we should have begun tightening earlier. Especially since food and fuel inflation that are outside the control of monetary policy account for a higher share of the consumption basket  ..

My biggest worry now is that even as there is no escape from hiking rates, that alone will not suffice to bring down inflation. At the same time, it will impact growth adversely. Frankly, all central banks are batting in the dark. RBI has often been accused of being behind the curve, of being late to withdraw the extra liquidity. Maybe we were. But many countries where central banks raised interest rates well in advance have not had much success in controlling inflation either. So, the fact we w ..

The reality is economists don't quite understand inflation. Or its remedies. US Fed chair Jerome Powell admitted as much in a speech on June 22, when he said, 'I think we now understand better how little we understand about inflation'. I can't voice such thoughts here because then the public will lose faith in us, and it is important, above all, to keep the faith. More so, since we believe it will take another 12-18 months to get inflation down to 4%.

I end by echoing Powell's words, 'Certainly there is a risk we will go too far. But failing to restore price stability would be an even bigger mistake at the economic, political and the human level.' I am mindful that general elections are a little over a year away. But I hope you will continue to repose your trust in us.

Source Name:-Economic Times


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