In a span of just a month, there are two reports on inflation band and the composition which offers indirect advice to the government in reviewing the monetary policy committee (MPC) framework, which is due in March next month.
The RBI working paper co-authored by Reserve Bank of India Deputy Governor Michael Debabrata Patra, who is also a member of the six-member monetary policy committee (MPC) has recommended that maintaining the inflation target at 4 per cent is appropriate for the country. "If it ain't broke, don't fix it," the paper stated.
In addition, the paper reasoned that setting an inflation target below the trend may impart a deflationary bias to monetary policy because it will go into overkill relative to what the economy can intrinsically bear in order to achieve the target. Similarly, a target that is fixed above trend renders monetary policy too expansionary and prone to inflationary shocks and unanchored expectations.
A month later, the Economic Survey presented by the CEA Krishnamurthy Subramanian questioned the inflation benchmark itself by making a case for focussing on 'core inflation' as the anchor for deciding the policy rates instead of Consumer Price Index (CPI). Currently, headline inflation or the CPI, which also includes food, is the anchor for the MPC to track inflationary pressure in the economy. "Food inflation, which contributes significantly to CPI is driven primarily by supply-side factors," argued the survey.
So whose advice should the finance minister Nirmala Sitharaman follow -- RBI or Chief Economic Advisor?
The finance minister has said that the inflation target of 4 per cent with a band of 2 per cent to 6 per cent is up for review as the current MPC framework under which the country's interest rate is set is nearing its five-year term in March next month. She didn't say anything more. the next step would be a consultative process which will include RBI Governor and the Ministry of Finance. The advice of CEA will also be taken before deciding on the new framework.
In the last five years, inflation as measured by CPI fell from 5 per cent per cent in 2016 when the MPC was constituted, to below 2 per cent level in January 2019. But the average CPI or retail inflation has been on the rise for over a year. In fact, inflation has been over 6 per cent for the last few quarters. In July last year, the CPI recorded was much higher at 7 per cent. Part of the reason was the pandemic and breakdown of supply chains. The inflation has now dropped in December and January to 4 per cent.
The government will certainly take into account the next five years, which are challenging because of the contraction in GDP and the recovery process. The higher market borrowing and the fiscal consolidation path have to be taken into account for managing the yields in the government securities market.
There is a likelihood that the inflation target could be tweaked to accommodate the government's higher borrowing plan of Rs 12 lakh crore in 2021-22. The government had borrowed Rs 12.80 lakh crore in 2020-21 due to pandemic, which resulted in lower tax revenues and additional expenditure on healthcare and social spending.
In addition, the next five-year inflation target is very important in view of a long five-year fiscal consolidation path to 4.5 per cent fiscal deficit by 2025-26. The fiscal deficit has already skyrocketed to 9.5 per cent in 2020-21. The government has budgeted a fiscal deficit of 6.8 per cent of GDP in 2021-22.
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