RBI Monetary Policy: How to Ensure Policymakers Don’t Mess Up?

“RBI‘s policy dexterity needs to be complemented with better inflation data”: Dr Sachchidanand Shukla, economist

The RBI stood pat on the policy rates in Friday’s (5 February 2021) policy meeting. The rate cut cycle is largely over and it is widely expected that monetary policy will focus primarily on liquidity management in 2021. While the RBI highlighted several upside risks to inflation stemming from cost push pressures, we believe that any interest rate moves are unlikely in the near-term, even in the case of a surprise increase in inflation given the RBI’s commitment to focus on growth.

The RBI also assuaged fears of a disruptive withdrawal of liquidity from the markets while stressing that it is committed “to foster congenial financial conditions for the recovery to gain traction”. Such forward guidance is commendable given that the focus now shifts to the normalisation of liquidity conditions as the economy recovers in FY22.

Current CPI May Not Accurately Represent Actual Inflation Levels: Why This Matters

The next big event on the policy front is the Review of the Monetary Policy Framework, which is due in March 2021, as the outcome of this exercise could affect the trajectory of policy rates in the near term. There is considerable debate around the fixing of the inflation targets and a recent RBI working paper, that was authored by the RBI deputy governor, had argued for maintaining the inflation target at 4 percent.

We have highlighted on multiple occasions that the debate around appropriateness of the inflation targeting framework misses an important point – the signalling power of the underlying benchmark Inflation index, the quality, and its composition.

Any discussion around the appropriateness of the inflation target has limited utility if the benchmark inflation Index is not appropriately measuring the underlying.

The moot point here is that the current Consumer Price Index (CPI) may not be accurately representing the actual inflation levels seen in the economy.

This is a particularly dangerous proposition for Monetary Policy guided by a flexible inflation targeting framework as the misrepresentation of the inflation trajectory, even if temporary, could lead to a substantial difference in historical as well as future policy outcomes. Recall Dr Subbarao’s lament on underlying data quality and that the RBI "is oftentimes wrong-footed because of the questionable quality of data".

CPI Data & The Problems It Suffers From

The CPI data suffer from a number of problems. The representativeness of the underlying consumption basket is an issue. The weights for the CPI basket were set a decade ago, with the base year being 2011-12. Since then the per capita incomes have more than doubled and household consumption patterns are likely to have changed substantially.

This change is likely to have been away from food to non-food items implying that the weightage of food, which is the most volatile sub-group in CPI, is likely to have come down.

This is exactly what had happened between 1999-00 and 2011-12; as per the Consumption Expenditure Surveys, the share of household spending on food items dropped by 10.8pp and 9.6 pp in rural and urban India, respectively during this period. Even within the food sub-group the consumption pattern is likely to have moved away from cereals (which is 25 percent of food by weight) towards pulses, fruits and processed food with the rising per capita incomes.

Then we have the problems related to the data sources for price collection.

This also needs to be expanded to include digital channels given the shift to e-commerce, away from brick and mortar stores. There should be a rethink on the sampling side at the first level – especially due to the pandemic and how people’s preference for shopping possibly is changing and these behavioural changes may be sticky. Capturing online price points would be important to augment the CPI data.

What Policymakers Must Bear In Mind

These issues have gained ground recently and this is a positive sign. As per the minutes of the October 2020 policy meeting, one Monetary Policy Committee (MPC) member had highlighted the need to rebase the CPI to more accurately reflect the lower share of food in the consumption basket. Further, the Economic Survey had also stressed on some of these issues and the need to include e-commerce transactions in the construction of price indices.

Transitioning from the current static system of consumer price computation to a more dynamic one, wherein weights and items are re-thought every 2-3 years, would be key to ensure the effectiveness of monetary policy and ensure that policymakers do not err in policy decisions.

(with inputs from Rahul Agrawal, Economist, Mahindra and Mahindra Group)

(The author is Chief Economist, Mahindra and Mahindra Group. This is an opinion piece, and the views expressed are the author’s own. The Quint neither endorses nor is responsible for them.)