Now that the Finance Minister has presented the Union Budget which is neither populist nor expansionary, all eyes will be on the Reserve Bank of India as it gets ready to announce the monetary policy on February 8. Inflation in India seems to be on a downward trajectory from the high levels it had reached in the first half of 2022. Yet the RBI must be cautious about taking its foot off the pedal as far as taming inflation is concerned.
The RBI has been following an inflation targeting framework for conducting monetary policy since 2016. The framework mandates the RBI to achieve a CPI (consumer price index) inflation target of 4 percent. For the most part of calendar year 2022, CPI inflation averaged at 6.9 percent. The inflation target was not achieved for 10 consecutive months in 2022.
From October onwards inflation seems to have been declining. The average CPI inflation in November and December came down to 5.8 percent. This means that inflation is now back within the RBI’s tolerance band. This is a positive development not only because inflation seems to be moving towards the 4 percent target but also because high inflation disrupts macroeconomic stability.
However this recent decline should not be interpreted to mean that inflation has ceased to be a problem. There are four main reasons why risks to inflation persist.
First, while headline inflation has come down, core inflation (non-food, non-fuel) has been quite stubborn. In December 2022, core inflation was 6.2 percent, same as the full-year average. Infact core inflation has been sticky around 6 percent for almost three years now—from April 2020 to December 2022. Persistent core inflation implies that price pressures have become embedded in the system.
There may have been three phases that can help explain the core inflation dynamics. In the first phase, once the pandemic hit India, and widespread mobility restrictions were introduced, supply chain bottlenecks became intense, services were shut, goods and labour were hard to come by. This started putting upward pressure on core inflation. In the second phase, as the land war broke out in Europe in February 2022, input prices skyrocketed and manufacturing firms began passing on the higher costs to consumers. We can then think of a third phase, when commodity prices began easing thereby softening the input price pressures on the producers but services began actively normalising. For two years the services sector could not adjust wages and prices. Now that the economy has fully opened up, they are having to pay higher wages to workers to compensate them for the price increases that occurred while they were away, and are adjusting prices accordingly. This is keeping the core inflation high.
Apart from core inflation, cereal prices have been steadily going up. Between May and December 2022, cereal inflation more than doubled. Within cereals, inflation in wheat went up drastically from 9 percent in May to 22 percent in December, while inflation in rice increased from 3 percent to 10 percent during the same period. Food accounts for 46 percent of the overall CPI basket and within the broader food-group, non-perishables such as cereals, spices etc., have almost a 37 percent weight. This means that these items determine the underlying trend in CPI food inflation. Non-perishables inflation increased from 5 percent in November to more than 8 percent in December 2022, reaching the highest level in more than two years. In fact, much of the decline in overall CPI inflation both in November and December was driven by perishables such as vegetables which registered a steep fall in prices. Excluding vegetables, CPI inflation increased to 7.2 percent.
Third, while inflation in the developed world has also been coming down, it is still quite high. Inflation in the US was 6.5 percent in December, while inflation in the European Union as well as the UK remains more than 9 percent. Through the channel of international trade in goods and services, India continues to import this high inflation.
Finally, as China opens up after three years of Covid-related restrictions, recovery of its economy from a growth slump is likely to exert upward pressure on commodity prices, given that China accounts for a large share of global commodity demand. This may fuel inflationary pressures in India which imports commodities.
What should therefore be done by the policymakers?
The government seems to have done its bit. With nine state assembly elections scheduled between now and January 2024, and the country going into general elections in 2024, the apprehension was that the government would announce a slew of populist measures in the Union Budget presented on February 2nd. This would not only disrupt fiscal consolidation, it could also aggravate inflation. Strikingly enough, the government has not given in to populist demand pressures. It has announced a steep increase in capital expenditure which is undoubtedly a demand stimulus but a lot will depend on implementation.
Now the ball is in the RBI’s court. It needs to remain vigilant on inflation. While the central bank has been tightening monetary policy from May 2022 onwards increasing the repo rate to 6.25 percent, it now needs to clearly indicate when it expects inflation to reach the target level of 4 percent, and what its plan of action is to bring this about, particularly to break the persistence of the core inflation.
A low, and stable inflation generates macroeconomic stability and creates a favourable environment for growth. On the other hand, high, sustained inflation hurts the poorer sections of the society the most and can have a detrimental political effect in an election year.
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