Decoding RBI annual report: Killing inflation only way to achieve sustainable growth

There are no better ways to know the thought process within the Reserve Bank of India (RBI) than paying attention to its language in its periodical publications that lists out its macro economic priorities and dilemmas. The apex bank leaves enough clues on matters close to its heart.

In the annual report released on Thursday, the RBI talked a lot on the benefits of inflation targeting, for its own good reasons. For a growth-hungry government and struggling industries, waiting for the first rate cut from the RBI that will bring down their interest costs, these words may not give much reasons to rejoice.

Inflation targeting, in economic parlance, refers to a stated policy of the central bank in which the apex bank make public a specific target for inflation and attempts to achieve that target through the use of available monetary policy tools.

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There were several mentions, with unprecedented emphasise regarding the benefits of having an inflation targeting central stance for monetary policy. Those who compiled the annual report has spent sufficient time to choose the words that will best fit to justify why inflation targeting is indeed a good policy for India.

Some of them are listed here:

“A strong, transparent, predictable and effective monetary policy framework is needed to deliver low inflation. Greater central bank credibility on inflation allows it to use monetary policy in a counter-cyclical fashion,” the RBI said detailing the need for strengthening the monetary policy framework.

It further says: “With the annual average consumer price inflation touching double digits or near for the last six years, establishing a credible nominal anchor to rein in inflation and anchor inflation expectations assumes importance.”

The RBI draws comfort from international experience: “Several countries have adopted inflation targeting with instrument independence for their central banks.”

“In many cases, this has helped deliver low inflation. While some of these countries neglected financial stability with attendant costs that came to fore during the global financial crisis, flexible inflation targeting and financial stability are not mutually exclusive goals. In fact, low inflation helps secure monetary as well as financial stability.”

That sums up the thought process in the RBI and a causal translation of the above graph could be this:

“Look guys, world around people have accepted inflation targeting as the best way to deal with macro-economic problems. Killing high inflation is the only path to achieve everything else you might want-a safe financial system and an environment for sustainable economic growth. We need to act now.”

The Indian central bank already has its inflation targets ready. The RBI wants 8 percent retail inflation by January, 2016 and 6 percent by January, 2016.

In its August bi-monthly policy, the RBI kept its key policy rate unchanged, drawing comfort from a gradual easing in the inflation numbers and said it will observe the price indicators in the subsequent months to take a call on its monetary stance.

Now, read the caution statement in the annual report.

“Subsequent data release in terms of a higher consumer price index (CPI) inflation driven by vegetable price spike indicate that the upside risks to this assessment persist,” the RBI said in its annual report on Thursday.

The retail inflation number rose to 7.96 percent in July from 7.46 percent in June, and was largely on account of fruits and vegetable items (which increased by 22.48 percent and 16.88 percent respectively).

Core inflation stood at 7.4 percent. Food inflation in July rose to 9.36 percent as against 7.97 percent in June. On the other hand, industrial production fell to 3.4 percent in June from 4.7 percent in May.

Though some moderation in CPI, excluding food and fuel inflation, is visible in recent months, the extent of moderation warranted by the significant growth slowdown is yet to manifest in CPI, the central bank states.

“Such rigidity in the core component of inflation points to the inertial nature of inflation feeding into the elevated inflation expectations, which would necessitate credible anti-inflationary monetary policy to provide a nominal anchor and break the inflation persistence,” the RBI said in the report.

Conclusion: The RBI has embraced inflation-targeting as its central policy stance even though Rajan is yet to openly admit it -probably because it is difficult to convince any political regime about the idea. Justifying inflation targeting as a formal policy stance in an economy where growth is at a subdued rate is indeed an uphill task.

Going by the language in the report, the central bank still sees upside risks to its central targets on achieving the inflation path and will be willing to lower the guard only at a time when it sees material evidences of disinflationary process progressing on the expected path.

Any aberrations from that path would mean the wait for interest rate cuts gets longer. Jaitley will do well if he accepts this reality.

For now, chances for a rate cut in the 30 September policy looks nil.