Dusting off the inflation cap

In early July, the statistics office released the inflation numbers for three months — April, May, and June — all together, following some pandemic-related delays in data processes. Most had assumed inflation to be in the 5-6 per cent range, but it came in higher at 6-7.5 per cent, well above the Re­s­erve Bank of India’s (RBI’s) 4 per cent target.

The popular narrative on inflation is that the rise was because production and distribution had ceased due to the pandemic, leaving too many buyers chasing too few goods. And as the economy gets back on its feet, this supply shock will temper, while the collapse in demand will remain, pushing the inflation rate lower. Supporting this will be a favourable statistical base from last year, pushing inflation numbers even lower than the 4 per cent target at the end of 2020. Recall that vegetable prices jumped in late 2019, pushing overall inflation up.

And yet, for three good reasons, inflation may need closer monitoring now than in the recent past.

One, real interest rates (calculated as the nominal interest rate minus inflation), which have been a driver of inflation in the past, are nearing negative territory after six long years.

Let us explain. India’s experience with inflation over the last decade can be divided into two phases, and both these phases have a strong relationship with real rates. During the FY09-FY11 period, the inflation rate rose rapidly, averaging 11 per cent. This period was characterised by negative real rates.

And then, all of a sudden, inflation began to fall, from 9.9 per cent in FY13 to 3.4 per cent in FY19. This period was characterised by positive real rates.

The inflation environment seems to be at a crossroads this year. With real rates now at zero, whether they go positive or negative over the next few months could help determine the trajectory of inflation.

Two, there are risks that inflation expectations, which are an important driver of inflation, could start to shift. Inflation expectations tend to be stubborn, stemming from past inflation and leading to future inflation. It is no surprise that in the period when inflation was rising, inflation expectations were on an upward spiral, and when the rate was falling, so were expectations.

Over the last five years, the inflation ecosystem has been supportive. Real rates were positive and government policy, too, was helpful (for instance, more rules-based rather than discretion-based increases in minimum agricultural prices).

But with real rates now falling, expectations will face their biggest test of the last few years. Were they subdued because other factors are supportive, or have they truly become anchored at low levels?

Three, to avoid further supply disruption, viable firms may need more credit to survive; but a risk-averse banking system may not be ready to help.

In our mind, there are three specific supply-side disruptions to think through: Those caused by labour, logistics, and finance. Of the three, the finance-led one may last the longest.

About 85 per cent of India’s labour force is employed in the informal sector, which de­pends largely on cash and does not have en­ough buffers to withstand large economic shocks like lockdowns. If viable firms fail, India could find itself staring at large su­pply-side constraints, which could beco­me inflationary as demand begins to tick up.

To keep viable firms alive, the banking system needs to allocate credit efficiently. But here we find that banks themselves have become extremely risk-averse, fearing a large mountain of bankruptcies and non-performing loans through the pandemic.

Banks have not passed on repo rate cuts to lending rates adequately. And credit growth, which was already weak, has weakened further over the pandemic months. It is possible that the lack of funding will eventually stoke inflation.

What does all of this mean for the RBI? In supporting the economy since the start of the pandemic, the RBI has touched upon each of its functions — rate setting, liquidity infusions, and regulation. The benchmark repo rate has been cut by 115 bps, the banking sector is now flush with liquidity (Rs 6 trillion), and the loan moratorium has been extended.

As the impact of previous easing unfolds through the system, and the inflation traje­c­tory becomes a tad more uncertain, we be­l­ieve the RBI may want to pause on rate cuts in the upcoming August 6 policy meeting. Ha­­ving said that, we expect it to hold on to its accommodative stance and emp­h­a­­s­ise that there is space to cut more if the ec­o­nomy so requires. We also think that domestic liquidity will be kept in surplus for a prol­onged period, becoming the RBI’s do­­m­­­­­inant tool for easing over the next few months.

The writer is chief India economist, HSBC Securities and Capital Markets (India) Pvt Ltd