<b>Abheek Barua:</b> Why the fuss about inflation?

The decision by the Reserve Bank of India (RBI) to hold the policy rate when the markets (including myself) expected a cut led to massive sell-off in the bond market reversing the downward trajectory that bond yields had been moving on for the past few months. The 10-year benchmark bond yield climbed nearly half a percentage point since the policy. What added to the momentum of the rise in yields was the central bank’s shift in stance from “accommodative” to “neutral” — gobbledygook that basically means that this was perhaps the end of rate cuts for the foreseeable future.

To be fair to RBI, perhaps we should have seen it coming. Many of those rooting for a cut betted on an assumed quid pro quo between RBI and the government — fiscal rectitude in return for a rate cut. Clearly there was no such deal. Others would have fretted about the impact of demonetisation on growth but RBI had indicated that it views it as transient. We should have also looked harder at the core inflation (stripped of food and fuel) data that have remained sticky at close to 5 per cent for some time. Thus the pretty retail inflation prints that we have seen recently (January recorded a two-year low of 3.17 per cent) came largely on the back of falling vegetable and dal prices and could be ephemeral. The much discussed base-effect that has kept inflation low will turn adverse and bootstrap the inflation rate up with it. International crude prices and commodities and general have firmed up and if the US were to provide a dose of fiscal stimulus they could rise further. RBI has also raised concerns about volatility in the rupee and the prospect of depreciation if interest rate hikes in the US sucks dollars out of markets such as India. A cheaper rupee would mean costlier imports.

Thus, prima facie, RBI seems to have a watertight case. However, the need to reconcile the story of an economy that is quite clearly operating well below potential both in terms of its performance on growth and employment with rising inflation pressures remains. One way to do this reconciliation is to look below the headline numbers like GDP growth and seek pockets where demand outstrips supply. While manufacturing both in the large and small scale segments remain saddled with overcapacity and weak demand, the market for skilled services such as health and education have a problem of chronic excess demand or under-supply. Ditto for the housing market where any upward pressure on demand (such as the hikes in housing allowance as part of the pay revisions of central government employees) could translate into an escalation in rents and possible home prices.

Two questions become pertinent then. If the industrial segment is indeed suffering from excess capacity, could a rise in imported input prices translate into a more generalised form of inflation by nudging output prices up? Going through wholesale price inflation data where the headline print rose to a somewhat alarming 5.2 per cent in January, I notice the entire upward pressure is coming from input prices while output prices remain subdued. In other words, margins are getting compressed and might impinge on companies’ willingness to spend on hiring or capex. This could actually be deflationary. 

The second question relates to whether the central bank should address the issue of chronic supply shortages that drive services inflation (doctor’s fees, school tuition etc) through interest rates or should it learn to “look through” these impulses when considering rate action. This will prevent a situation where the dent on these price pressures is negligible compared to the more binding costs of elevated interest rates — high EMIs that restrain consumer borrowings, high cost of capital that impedes investments all adding up to weak demand.

Illustration by Binay Sinha

These are difficult questions to answer given that RBI has got itself a mandate to certainly keep inflation below 6 per cent and actually try to get it down to a 4 per cent level in the medium term. The suggestion that one keeps stripping out items from the “target” if supply problems dominate can perhaps get RBI a better gauge of the demand side but this abstract inflation index might be seen by those outside the tiny world of economists as arbitrary and meaningless. Thus those who were on my side and made a strong case for a rate cut in this policy have to perhaps accept high rates as the inevitable cost of shifting from a discretionary policy raj to a more rule-based model.

However, at this stage RBI might not need to worry too much about the impact on borrowers. Demonetisation has both flooded banks with deposits and harnessed the demand for credit. Over the last three months the credit-deposit ratio of banks has declined by a good five percentage points. Thus even without a policy rate cut, there is internal pressure on banks to lower rates and chase assets. In fact, RBI sees rise in demand on the back of cheaper borrowing as a risk for inflation going forward.

However, this is a one-off situation and might not persist for very long. 2017 promises to be a tricky year with major changes likely on the global front as the Donald Trump administration pushes the protectionist agenda and the Fed lifts its foot off the interest rate brake. RBI could provide a textbook response that might not be entirely in the interest of the domestic economy. Some nimble-footed discretion is perhaps the need of the hour.
 

The writer is chief economist, HDFC Bank. Views are his own