Inflation control: What can the RBI do and what it cannot do?

The inflation in wholesale prices measured by growth in Wholesale Price Index (WPI) was 13.68%, 13.11% and 14.55% and 15.08% in January, February, March and April this year, as per latest data released on 17th May.

Since April last year, WPI has been above 10% every month.

This is not the first year when the country has faced double-digit inflation but sources and duration have been different.

Prices can rise due to multiple reasons. A drought, flood or pandemic affecting production/supply of goods can create demand-supply mismatch. An abundant supply of cheap credit can fuel demand-push inflation –too much money chasing too few goods. Emergence of monopoly producers with pricing power can push up prices. High taxation can push up prices. High cost of imported crude oil can push up prices.

While many of these factors were already at work, the Russia-Ukraine conflict, resultant food shortage and crude oil price hike has resulted in global inflation surge. There are dominant concerns on inflation despite some other short-term gains. Inflation is indeed causing worry now.

As the pandemic ebbs, there has been heavy demand surge while the production and logistics that got stalled during pandemic is yet to pick up fully creating a demand supply gap. Inflation on the inputs side is being passed on by manufacturers to the output prices.

As the margins of the manufacturers have been under pressure due to rising input costs, transportation, and logistics, they are passing on these into their output prices leading to higher inflation in manufactured products. The higher input costs, especially of raw materials, have aggravated due to the Russia-Ukraine conflict.

Who can remedy the situation and how?

The Reserve Bank of India controls the extent of supply of money/credit in the market keeping in mind several factors like the foreign currency exchange rate and inflation.

To some extent, the RBI can control demand push inflation if it is caused by excessive money supply.

However, if the production fails, if the logistics fails or if the monopoly producers dictate prices or if the prices go up due to taxation, there is little that the RBI can do.

This is a short comment on the ‘inflation targeting’ by the RBI.

In 2016, the Reserve Bank of India Act, 1934 was amended and a whole new chapter was added on ‘Monetary Policy’.

One of the newly inserted provision in the Act (Section 45ZA) introduced a system of Inflation target. It mandated that tThe Central Government shall, in consultation with the RBI, determine the inflation target in terms of the Consumer Price Index(CP)I), once in every five years. A Monetary Policy Committee and a mandatory Monetary Policy Report was introduced.

The Act stipulated that if the RBI fails to meet the inflation target, it shall set out in a report to the Central Government— (a) the reasons for failure to achieve the inflation target; (b) remedial actions proposed to be taken by the Bank; and (c) an estimate of the time-period within which the inflation target shall be achieved pursuant to timely implementation of proposed remedial actions.

For the five years 2016-21, the government notified consumer price inflation target of 4 percent with toleration deviation in the range of 2 percent to 6 percent. The same target has been extended for next 5 years.

The CPI has now breached 6%. As per the law, the RBI has to ‘explain’ to the government why it is so?

CPI has a large weight of food and fuel prices which are out of the control of RBI. RBI cannot control either international crude prices nor petrol products’ taxation nor food supply disruption due to bad weather. Food and fuel demand is not much influenced by cost and availability of bank credit! (Does one buy more food and fuel if more low-cost bank credit is available? No)

WPI pertains to only goods, not services. So, the WPI basically captures the average movement of wholesale prices of goods and is used for comparing changes in Gross Domestic Product (GDP) at current market prices.

GST collections have been growing in recent months sowing the success of government in cracking down on tax evasion. One fall out of this crackdown is that prices go up because what was being sold earlier without tax on kutcha bills is now being forced to be sold on pucca bills. So in a way tax evasion and inflation are inversely related.

Let us hope that increased tax collections, increased tax compliances nudges the government to lower tax rates. A beginning has been made by reduction in Central taxes on petroleum products. Rationalisation of GST rates is awaited.

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