There is a great deal of concern about the path of monetary policy, given that headline inflation has breached the required range, from 2 to 6 per cent CPI inflation, in 7 of the latest 8 months. The inflation data, however, reveals a surge in prices in April 2020, which was also the month where the lockdown hampered supply. As supply constraints ease, inflationary pressures are likely to ease. The MPC is on the right track in seeing through these short term fluctuations, and looking at forecasts of inflation about 12 to 18 months out. The de facto policy rate has been cut steadily from 7 per cent to 3.23 per cent over the last 18 months, which is the wise path.

 

While the inflation target is at 4 per cent, the permissible range runs from 2 to 6 per cent. For 7 of the latest 8 months, headline inflation (the year-on-year change in the CPI) has gone above the upper bound of 6 per cent. This is the cause of considerable concern. The inflation targeting framework, which was setup in February 2015, has worked very well so far. These eight months are the first episode where the framework has not worked.

 

Monetary policy impacts the economy with a lag of about 12 to 18 months. Therefore, a simple reading of the inflation crisis from December 2019 to July 2020 would suggest that the policy rate was too low in the period from June to December 2018, that the MPC in those months failed to anticipate this surge in inflation in the future. The policy rate peaked at 7 per cent in September 2018 and then the rate cuts began: perhaps this timing and the scale of the cuts was excessive.

 

The table superposes the latest 18 months of conventional headline inflation (the year-on-year change of CPI, i.e. the average of 12 month-on-month changes) and the month-on-month CPI inflation (which is `POPSAA', i.e. point-on-point seasonally adjusted and annualised).

 

Month Year-on-year Month-on-month

 

Month	Year-on-year	Month-on-month
Feb-19	2.56	7.25
Mar-19	2.85	5.77
Apr-19	2.99	5.19
May-19	3.04	5.39
Jun-19	3.17	4.74
Jul-19	3.14	1.41
Aug-19	3.27	4.4
Sep-19	3.99	9.67
Oct-19	4.61	7.27
Nov-19	5.53	10.03
Dec-19	7.35	22.13
Jan-20	7.59	4.04
Feb-20	6.57	-4.14
Mar-20	5.84	-2.33
Apr-20	7.22	20.82
May-20	6.26	-4.87
Jun-20	6.22	4.45
Jul-20	6.93	9.61

 

The values in boldface are the months where headline inflation breached the required range of 2 to 6 per cent.

 

The conventional headline inflation measures the change in CPI over a 12 month period. It is useful to break this down to a set of 12 month-on-month changes, which is made possible through seasonal adjustment. When we examine this data, there was a surge of inflation from September 2019 to December 2019, where the month-on-month inflation had values of 9.67, 7.28, 10.04 and 22 per cent. This subsided in the following months.

 

After this, came the lockdown. The peak intensity of the lockdown was in April 2020. The lockdown has had an adverse impact upon supply chains. There have been shortages of many goods. Under these new supply/demand conditions, prices have risen to clear the imbalance between supply and demand. This explains a lot about current inflation. If one value (+20.82 per cent in April) was not in the data, the 11-month average is now at 5.5 per cent. Monetary policy acts on horizons of 12 to 18 months; the MPC should not have paid great heed to such transient factors.

 

The easing of the lockdown began from 18 April. This process is now well underway all over the country. It is likely that the supply situation eased in August and will ease further when the Kharif crop comes in. By September, headline inflation is likely to be lower.

 

Turning to the conduct of monetary policy, there are many instruments through which RBI influences monetary conditions, i.e. the short-term interest rate. These instruments include the repo and reverse repo rates, open market intervention, currency trading, etc. The best summary statistic that portrays the true state of monetary policy is the 91 day treasury bill rate on the secondary market.

 

This rate dropped from the recent peak of 7% in September 2018 to 3.23% in July. This is a total rate cut of 377 basis points, which works out to an average cut of 14 basis points every month. By and large, this reflects a sensible assessment of the difficulties in the economy. Looking beyond the temporary dislocation associated with lockdowns, conditions in the economy may be difficult for a sustained period, and this reduction of interest rates is consistent with keeping inflation within the desired range. At a value of 323 basis points, the short rate is now negative in real terms even when compared with the 4 per cent CPI target.

 

The bottlenecks lie in financial policy. When RBI cuts rates, this has a low impact upon the economy. While monetary policy is pursuing the right objective (4% CPI), it is at present relatively ineffectual.

 

As an example, when banks are stressed, they are extremely cautious, they are loath to borrow at low rates and lend into the economy. This has induced a decline in the growth of bank credit. In the recent period, the growth of bank credit peaked (yoy) in December 2018, at about 15% and has declined ever since. The latest value for July is 5.64%. From December 2019 onwards, this growth rate has been near zero in real terms, with a slightly negative value for July 2020. If banking regulation had been better, banks would not have been in such a frame of mind.

 

Similarly, the bond market has retreated to a few trusted issuers; most borrowers are cut off from plausible bond market access. As a consequence, the cost of borrowing remains high, even though the de facto policy rate is at 3.23 per cent. If financial markets regulation had been better, there would have been a viable bond market, and this would have helped private and government borrowing.

 

These problems reiterate the need for financial sector reforms. There is considerable knowledge in hand, about why banking and the bond-currency-derivatives nexus in India do not work well. The full work program that would address these problems has been developed. The difficulties that we have faced, in the context of the pandemic, in macro/finance policy would be diminished if this work makes progress. We require institutional reform in financial regulation on a scale comparable to what was done with institutional reform in monetary policy.