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Explained: US inflation and its impact on India

At 6.2%, retail inflation in the US has made the highest year-on-year jump in 3 decades. Why is that a concern for India, where inflation has frequently breached the RBI’s comfort zone in the last 2 years?

Written by Udit Misra | New Delhi |
Updated: November 23, 2021 10:23:19 am
us inflation, global inflation, india inflation, us inflation explained, reasons for inflation, covid inflation, indian expressA worker puts bags of sweet potatoes in container in the warehouse of the Alameda County Community Food Bank in Oakland, Calif., on Nov. 5, 2021. (AP Photo/Terry Chea)

Over the last few days, rising prices have cornered a lot of attention, both globally and in India. On Wednesday, the United States’ Labor Department reported that retail inflation had spiked to 6.2 per cent in October. On Friday, India’s National Statistical Office (NSO) data showed that retail inflation rose to 4.5 per cent for the same month. A look at why this is a concern:

What is inflation rate?

It is the rate at which prices increase over a given period. Typically, in India, the inflation rate is calculated on a year-on-year basis. In other words, if the inflation rate for a particular month is 10 per cent, it means that the prices in that month were 10 per cent more than the prices in the same month a year earlier. If in the same month of the coming year, the inflation rate was to go up to 15 per cent, it implies that something that was priced at Rs 100 in the same month last year, and at Rs 110 this year, will be priced at Rs 126.5 next year.

A high inflation rate erodes the purchasing power of people. Since the poor have less money to withstand fast-rising prices, high inflation hurts them the hardest.

Why is US inflation a matter of concern?

On the face of it, Indians may not find a 6.2 per cent inflation rate a very sharp increase in prices. But in the US, this data is the largest year-on-year increase in the last three decades. Another way to put this data in perspective is that the Federal Reserve (or Fed), the US central bank, targets an inflation rate of just 2 per cent. Seen in that context, it is clear why the US inflation rate has become a massive concern for its citizens.

As the chart shows, retail inflation in the US has been rising sharply almost every passing month since May 2020. This has been a surprise for most policymakers and economists — all of whom were more focused on staving off a prolonged recession.

Trajectory of inflation rates (%)

What has caused the inflation surge in the US?

Typically, inflation spikes can be assigned to either an increase in demand or a decrease in supply. In the US, both factors are at play.

Thanks to a rapid rollout of the Covid-19 vaccination drive, the US economy posted a sharp recovery. Part of the inflationary spike came from this unexpectedly fast recovery in all-round demand from consumers. This recovery was further fuelled by billions of dollars pumped by the government to not only provide relief to consumers and those who lost their jobs, but also to stimulate demand.

Some experts are now wondering if this help from the government is worsening inflation. That’s because while demand has recovered swiftly, supply hasn’t. The pandemic in 2020 led to widespread lockdowns and disruptions not just in the US, but across the world. Companies let go of employees and sharply curtailed production. In essence, the supply chains of production, often spanning several countries and continents, were bent out of shape. Even during normal times, supply chains would have taken some time to recover and start furnishing the global demand. But the pace of economic recovery has been much faster than the supply chain recovery, and this has worsened the mismatch between demand and supply, thus triggering a sustained price rise.

Is this a US-specific phenomenon?

No. While the US has seen the sharpest increase in prices, inflation has surprised policymakers across most of the major economies, be it Germany, China or Japan. In Japan, for example, according to Bloomberg, the producer price index is at a 40-year high.

What is happening in India?

While most other economies were surprised by a spike in inflation in the wake of the pandemic, India was one of those rare major economies where high inflation predates the pandemic. As the chart shows, retail inflation had frequently been above the comfort zone of the Reserve Bank of India (RBI) — between 2 per cent and 6 per cent — for an extended period since late 2019.

The pandemic did make matters worse because of supply constraints even when in India demand has not yet recovered to pre-Covid levels. It is quite instructive that despite India entering a “technical” economic recession in September 2020, the RBI has not once lowered its benchmark interest rates since May 2020. That’s because India’s retail inflation has stayed worrying above or near the RBI’s upper limit for the better part of the last two years. It is only in the last couple of months that the headline retail inflation rate has sobered down to below 5 per cent.

Does that mean India’s inflation worries are over?

Far from it. This is partly because India’s inflation has stayed high even when demand hasn’t recovered. This means more inflation when it does. Moreover, while the overall inflation average appears quite manageable at present, it is the “core” inflation that is worrying observers now. Core inflation rate is the rate of inflation when we ignore the prices of food and fuel. Typically, food and fuel prices tend to fluctuate a lot. As such, looking at core inflation gives a more robust measure of what is happening to the general price level. The worry for India is that core inflation is now over 6 per cent. It was always high, and now threatens to breach the RBI’s comfort zone.

What’s worse, India’s inflation may worsen in light of the global increase in prices.

How does this impact happen?

When prices increase globally, it will lead to higher imported inflation. In other words, everything that India and Indians import will become costlier.

But there is a bigger worry. High inflation in the advanced economies, especially the US, will likely force their central banks, especially the Fed, to abandon their loose monetary policy. A tight money policy by the Fed and the rest would imply higher interest rates. That will affect the Indian economy in two broad ways. One, Indian firms trying to raise money outside India will find it costlier to do so. Two, the RBI will have to align its monetary policy at home by raising interest rates domestically.

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