The macroeconomic landscape in India seems to have suddenly changed. For most of this year, the main problem was surging prices, which had pushed consumer price index inflation far above the Reserve Bank of India’s target of 4 percent. In recent months however, inflation seems to have subsided. And now there is a new problem, as India’s export-led recovery is being threatened by weaking demand in the advanced countries, which seem to be slipping into recession. As a result of this shift in the landscape, some analysts have urged the central bank to shift its priorities, declaring victory over inflation, and focusing instead on the task of reviving growth.
At first blush, this shift seems reasonable. But we need to ask two questions. Is the inflation problem really over? And if not, what are the costs and benefits of shifting the policy stance?
Let’s understand the first question. It is true that inflationary pressures are softening. CPI inflation came out to be 6.8 percent in October, down from 7.4 percent in September. Alongside this, wholesale price index (WPI) inflation fell to 8.4 percent from an average of 14.9 percent in the previous nine months. It remains unclear though, whether these developments represent the start of a new trend or a temporary low. After all, core (i.e., non-food, non-fuel) CPI inflation has been running around 6 percent for the past three years, implying that inflation has become deeply ingrained at a level higher than the RBI’s target of 4 percent.
Moreover, there are still significant risks to the inflation outlook.
First, there has been a big spurt in the prices of cereals. Cereal inflation has gone up from 11.5 percent in September to 12.1 percent in October. In particular, the price of rice has gone up by 10 percent and that of wheat by more than 17 percent on a year-on-year basis. These developments are puzzling, considering that the government has been flooding the market, for some time, with cheap grains under both the PDS (Public Distribution System) and the PMGKAY (PM Garib Kalyan Anna Yojana) free food scheme that was launched in March 2020 as a Covid-relief measure. The latter scheme provides 5 kg of free foodgrains (wheat or rice) per person, per month for a family holding a ration card, and covers a significant portion of the population.
Why are cereal prices going up despite this massive free provision? One possibility could be that the government has used up much of the grains in its stock, and now the stocks are running low. If, on top of this, the winter wheat crop suffers, say due to the unseasonal October rains, then high cereal inflation could persist, thereby feeding a demand for higher wages, which would then translate into high general inflation.
Second, global inflation is still not under control. While inflation in the US has receded to 7.7 percent in October from 8.2 percent in September, inflation in the UK is 11 percent and rising, and that in the European Union has increased to 11.5 percent.
Third, the rupee may well remain under pressure in the coming months. As long as advanced country inflation remains high, their central banks will need to continue to raise interest rates from their historically low levels. Economists are currently expecting the US Federal Reserve to raise its policy rate by 100-150 basis points. The Organization of Economic Cooperation and Development (OECD) has recently indicated that rate hikes in the European Union would need to be even larger. These higher rates abroad will discourage capital inflows into India, which will be problematic for the rupee since India needs the inflows to fund its large and growing current account deficit.
For all these reasons, international and domestic, we can’t be sure yet that inflation in India is headed back to 4 percent. And this leads us to our next big question: should the RBI stay focussed on the inflation problem or should monetary policy instead focus on reviving growth? Consider the benefits and drawbacks of shifting its stance.
In principle, the main benefit of lowering interest rates is that it would encourage domestic investment. But it is far from clear that investment is being held back by high interest rates. In fact, private sector investment has been sluggish for the past decade, regardless of whether RBI policy has been tight or stimulative. As a result, it is difficult to believe that another shift in the RBI’s policy stance will make much of a difference.
Consider now the potential costs of such a shift. The most obvious cost is that stimulating the economy could worsen the inflation problem. However the biggest cost is perhaps much more subtle: when analysts urge the RBI to try to revive growth, they distract attention from the deeper policy actions that are required on the part of the government, namely the task of creating an economic framework that encourages firms to take risks and expand capacity. As a result, the reforms needed to revive investment are not undertaken.
In summary, we are still not out of the woods as far as inflation is concerned. Hence, we should let the central bank do its job, its legally mandated task of bringing inflation down to 4 percent. And we should encourage the government to focus on its mandate, of creating a supportive environment for investment and growth.
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