Inflation blues

Onus of reviving growth will solely be on govt

The latest inflation data has significantly increased the complexity of economic policymaking in India. Inflation, based on the consumer price index (CPI), increased sharply to 7.35 per cent in December, breaching the upper end of the Reserve Bank of India’s (RBI’s) target band of 2-6 per cent. The food inflation rate was at 14.12 per cent, compared with 10.01 per cent in the previous month, largely on account of higher prices of vegetables and pulses. Retail inflation has breached the target at a time when growth has slowed sharply. The Indian economy is expected to grow at just 7.5 per cent in nominal terms in the current fiscal year.

After cutting policy rates by 135 basis points, the monetary policy committee (MPC) of the RBI rightly decided to keep interest rates unchanged in December, largely due to inflation risks. Apart from the monetary policy, a pick-up in retail inflation will also influence the Budget 2020-21. Low inflation has been one of the biggest achievements of the National Democratic Alliance government. The upcoming Budget will, thus, have a tough task of addressing both slowing economic growth and rising inflation. A few days after the presentation of the Budget, the MPC will deliberate the course of the monetary policy. Although some analysts believe that higher food inflation is transitory and will come down in the coming months, the MPC is likely to take a more cautious view. While core is at a comfortable level, the latest headline inflation reading has ruled out the possibility of a rate cut in the February meeting. 

However, the bigger question now is: Till when will the MPC keep the policy rates on hold? There are two important points to note. First, as a research paper by the RBI — or the so-called Mint Street Memo — noted in May 2019 that large inflation-forecast errors in India had been related to unanticipated shocks from food prices, particularly those of perishables like vegetables. Cross-country evidence also suggests that forecast errors are associated with the weighting of food items in the CPI. Since the projections could not gauge food price shocks on the downside over the last few years, it is possible that it may not be able to do so even on the upside. Second, if the RBI fails to meet the inflation target for three consecutive quarters, it has to submit a report to the Central government, stating the reasons for failure, actions proposed, and the estimated time-period within which it will achieve the target. Undoubtedly, the central bank will want to avoid such an outcome. 

Thus, the coming months would be the biggest test for the RBI since the adoption of the inflation-targeting framework. In this context, it will be important to see to what extent the RBI changes its inflation projection and how food prices behave in the near term. A research note by the State Bank of India shows that an increase in vegetable inflation leads to an increase in protein inflation with a lag of two months. Further, global food prices have moved up significantly. Thus, with upside risks to inflation, the monetary policy will not be in a position to support growth in the coming quarters. The onus of economic revival will now solely be on the government and the Budget will be expected to provide a road map.