tightening mode before the 2008 crisis with the policy rate at 9%, sharply eased in response to the crisis: RBI’s benchmark repo rate almost halved over October 2008-April 2009 to 4.75%. Food prices—more reflected in the CPI—began to rise by June 2009, pushing retail inflation into double-digits; WPI inflation was relatively muted from base and global commodity price effects, but gained momentum in the second half of 2009. RBI then argued that monetary policy had little role to play in the face of supply shocks, as the drought was; its stance was more guided by the global situation, growth concerns and WPI inflation. By March 2010, WPI inflation crossed into double-digits, inflation became generalised over 2010-11 as food inflation spilled over into a wage-price spiral with a swift economic rebound in these two years.
This episode, or the persistence of inflation despite 13 interest rate increases in two years—RBI began to tighten from March 2010, lifting its policy rate from 4.75% to 8.5% by end-2011, mostly in 25 bps steps—sparked a debate about how much to tighten, whether the WPI was an appropriate indicator and if CPI should not replace it instead. Initially, most of the debate and discussions centered around the idea that the central bank should raise its WPI anchor to a higher level than 5%. RBI strongly defended its position not to do so. But somewhere down the line, the advisory changed track to move in the direction of new CPI from January 2012.
But was it under-measured inflation as per the WPI? Could it have been insufficient monetary tightening instead? A two-decade history of inflation and interest rate movements offers another perspective on this (see chart). The striking observation in historical context is that RBI’s policy rate, aligned to core-WPI inflation, remained well below headline WPI inflation throughout 2010-11, in marked departure from at least two-decade movements. Historically, RBI has set its benchmark rate well above overall WPI inflation, possibly reflecting cognizance of other price indicators, monetary aggregates, output gap and so on.
By this yardstick, it would appear that monetary tightening in 2010-11 was insufficient relative to overall inflation, output and other macro conditions. While the global financial crisis was a major shock, it is likely RBI did not adequately factor in domestic demand developments, notably, the exceptional fiscal expansion and a V-shaped recovery—GDP growth was then measured at about 8.4% in 2009-10 and