Persistent inflation will hurt growth

GDP growth for the second quarter of the current fiscal has come in at 8.4 per cent, up from a contraction of 7.4 per cent in Q2 of 2020. The uptick in part is because of the base effect, and allows for no firm conclusion on the revival of sustainable and durable growth. It comes in the context of inflation spikes that are very worrying.

Overall price levels in India represented by both retail and wholesale inflation are on the rise in recent months, slowly spreading across goods and services, with the trend becoming broad-based.  This represents a potential threat to anchoring inflation expectations and thereby controlling the actual rate of inflation. More worrisome is the unabated high rate of core inflation, telling us that inflation has become durable and thus raising questions on economic recovery in terms of non-inflationary growth. This is taking us far away from the promised land of the monetary policy objective, which simply is the dual mandate of “price stability keeping in mind growth”.

Higher fuel inflation has a cascading effect in the economy in terms of transport costs, higher irrigation and tractor input costs and could impact food prices

The inflation rate, officially measured as headline Consumer Price Index – Combined, or CPI-C, (base 2012), comprising food, fuel and services, has been continuously above the average of 4% since October 2019. This exceeds the target upper ceiling mandated in the Flexible Inflation Targeting (FIT) framework in force for the period March 31, 2021 through March 31, 2026.  While setting out the outlook for 2021-22, the Monetary Policy Committee (MPC) has announced CPI-C at 5.3 per cent, with the Q1 of 2022-23 rate estimated at 5.2 per cent. Furthermore, it remained above the upper band of 6 per cent (within a range of 6.3 per cent and 7.6 per cent) on 13 occasions during the period November 2019 through June 2021. It has subsequently declined below 6 per cent but remains above the mandated average rate of 4 per cent with no signs of declining below that.

Headline CPI-C inflation for most part during the pandemic was impacted by food inflation touching 12.20 per cent in December 2020, which has a weightage of around 45.86 per cent in the basket of commodities used to calculate inflation. The recent uptick in the retail inflation rate was contributed by fuel inflation (weightage of 6.84 per cent), which was in double digits during the period May 2021 through October 2021 and touched a high of 14.35 per cent in October 2021. We exclude food and fuel inflation (as these are sensitive to exogenous factors) from the headline retail inflation to arrive at what is called core inflation to gauge the persistence of inflation. Core inflation during the past 18 months beginning April 2021 through October 2021 was continuously above the FIT target of 4 per cent headline inflation. It crossed the upper band o the headline on more than three occasions and was as high as 6.39 per cent in May 2021.

The recent inflation print is more alarming in respect of Wholesale Price Index (WPI). WPI inflation for all commodities recorded a double digit increase continuously during the period May 2021 through October 2021 within a range of 10.66 per cent and 13.11 per cent. The recent uptick in WPI inflation is contributed by fuel inflation (within the range of 13.15 per cent and 37.18 per cent during the period) and manufactured inflation (10.96 and 64.23 per cent). Manufactured inflation is the core part in the WPI inflation.

The above analysis of  theinflation rate reveals that fuel inflation and core inflation are a matter of concern. Higher fuel inflation has a cascading effect in the economy in terms of transport costs, higher irrigation and tractor input costs and could impact food prices. Consequently, food inflation could be higher.  Closely related to fuel inflation are the domestic pump prices which have remained at very high levels. It is important to note that the rising energy prices not only impacts the output prices of agricultural products but also could contribute to adding pressure on manufacturing input prices. The volatility and uncertainties regarding fuel inflation and the cascading impact as explained above have the potential to result in a spillover to food and service inflation.

  An unremitting higher core inflation trend is a concern on two counts viz; (a) inflation expectation (which in the Indian case is generally adaptive) is distorted and anchoring of the same keeps the RBI under pressure as the inflation process critically hinges on the trend of inflation expectation and (b) core inflation is perceived to be mostly demand-driven, and persistence of the same for a longer horizon could spill over to higher headline inflation.

Another important aspect is resurfacing of inflation in advanced economies (AEs) and other emerging market economies. In USA, inflation is above 6 per cent and in Euro areas it is in the region of 4 per cent. In most of the emerging market economies, with inflation targeting, inflation is above the mandated target (for example Russia is at 8.1 per cent and Brazil 10.7 per cent in October 2021). Thus, there is pressure on domestic inflation in India, given the strong possibility of imported inflation adding up.

Economic growth has revived from the distressed level of a huge contraction (for example, around a negative growth of 24 per cent in Q1 of 2020) noticed in the early phases of pandemic. The MPC is hopeful of the Indian economy recording a growth of 9.5 per cent in 2021-22. One important aspect in the context of growth revival is the sustainability of growth both in the supply side (agriculture, industry and services) and demand side (consumption both private and government, investment both private and government and net exports).

In the above context, it is important to mention that supply chain disruptions now critically hinge on the speed, space and intensity of the spread of new virus variants and progress in vaccination. The demand side growth is largely dependent on the credit offtake by the private sector to augment private consumption and private investment. In the event of resurfacing of inflation, input cost in AES and emerging markets will swell the input costs and thereby leading to increases in output prices. Secondly, on account of the advent of new virus variants, the pandemic may well be all pervasive and jeopardise exports and imports. Contract driven services will be also adversely impacted resulting in higher service inflation and thereby making core inflation more persistent and endemic. Thus, emerging pressures on growth and inflation as explained above will impact the output gap (actual output minus potential output).

Monetary policy hereon will not have a straight walk

The empirical work of RBI (Study published in November 2021 RBI Bulletin) suggests that the negative output gap has increased within the range 4 to 6 per cent per quarter during the period Q2 2020 through Q1 2021.   Evidence suggests that inflation is sensitivity to output gap. The RBI study cited above also revealed that inflation expectation and output gap have a correlation coefficient of minus (-) 0,69. The study further states that there is positive correlation coefficient of 0.65 between the coefficient of the output gap and the output gap itself, implying that an increase in the output gap increases the sensitivity to inflation. What this is telling us is that the RBI has the most challenging job to address in terms of the growth inflation-trade off. As a result, the monetary policy hereon will not have a straight walk.

Though we recognise the limitation of the monetary policy but given the absence of any fiscal space on account of large fiscal deficit and debt relative to GDP, it is important that the RBI should continue its policy response to the emerging negative output gap and mandated inflation target in a credible manner.

In the end, the issue to recognise is the one raised in a speech (Sep.16, 2021) by the RBI Deputy Governor Dr. Michael Debabrata Patra, who said: “Monetary policy is all about the feasible. This inherently imposes a trade off with the desirable.” What is in the end desirable is non-inflationary growth but that appears less feasible in the present context.

(The writer is a former central banker and a faculty member at SPJIMR. Views are personal)