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Friday, August 19, 2022

It’s time for RBI to turn its attention to inflation

Dharmakirti Joshi, Pankhuri Tandon write: So far, it has not responded to high inflation. But recent trends will persuade it to turn focus back on prices.

A security guard's reflection is seen next to the logo of the Reserve Bank Of India (RBI) at the RBI headquarters in Mumbai (Reuters)

Until April this year, only wholesale inflation (WPI) was on the rise, led by fuel and commodity prices. But in May, even retail inflation (CPI) picked up, printing at 6.3 per cent. Notably, CPI inflation crossed the RBI’s upper limit of 6 per cent after five months. And the run-up was not just year-on-year (which can be somewhat discounted due to the data disruptions in April-May last year) but also on a sequential month-on-month basis. So what gives? And what does this change in inflation trajectory mean for us?

Rising inflation hurts lenders and benefits borrowers. To that extent, the government, one of the biggest borrowers, stands to benefit as high inflation will lower the national debt load in relation to the size of the economy. The Union budget 2021-22 assumed a 14.4 per cent growth in nominal GDP. However, actual growth is set to exceed this and could well be over 16 per cent as per our estimates.

We have recently lowered our real GDP growth forecast for 2021-22 to 9.5 per cent from 11 per cent. But our nominal GDP estimate has gone up from 15 per cent to around 16.5 per cent as we now expect WPI and CPI to average 7.4 per cent and 5.3 per cent respectively. The surprise surge in inflation makes even these estimates appear conservative.

The GDP deflator, which measures the difference between nominal and real GDP, is a weighted average of WPI and CPI, with a higher weightage to the former. And given that nominal GDP is used as a base for computing the fiscal ratios, all of these will get deflated, ceteris paribus. The value of past debt and debt servicing costs thus gets pared in real terms as inflation rises. Viewed from a debt dynamics perspective, as the gap between growth and interest rates rises, the debt/GDP ratio falls.

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That inflation reduces purchasing power and hits private consumption is well known. With incomes under stress, the impact on consumption can get magnified. What is important to note in the present context is that inflation is likely to hit private consumption in rural areas more than in urban areas.

Overall food CPI inflation (5 per cent) was lower than non-food inflation (7.1 per cent) in May. This is a continuation of the pattern observed in the past five months where food inflation averaged 3.5 per cent versus non-food inflation at 6 per cent. In 2020, however, the situation was just the opposite.

Lower food inflation, coupled with higher non-food inflation means reduced purchasing power for farmers — the terms of trade which were favourable for agriculture last year, are now worsening. Food inflation was, however, lower in rural areas vis-à-vis urban areas in May. So, what agriculturalists typically sell is rising at a slower pace than what they do not produce, and have to buy from the market.


Last year, a normal monsoon, a bumper crop and high food inflation in wholesale and retail markets added to rural incomes. Government support through ramped-up MGNREGA and PM-Kisan allocations, and record food procurement also helped. This year, the monsoon is projected to be normal, but MGNREGA support is budgeted at a lower level, and price trends are not supportive for the rural population.

Inflation trends, specifically input prices (reflected better by WPI), matter for corporate performance as well. While producers seem to be bearing a part of the burden of rising input costs for now, these could get passed on in greater measure to consumers once demand recovers. The RBI will have to closely monitor inflation trends and calibrate its policy response. It has not intervened on high inflation since the onset of the pandemic and, rightly so, in order to support growth. But the current spell of inflation is over a high base and a continuation of recent trends will persuade it to turn the focus back on inflation.

It is pertinent to note that with the repo rate at 4 per cent, the real rate (adjusted for inflation) has been negative for over a year. Rising inflation reduces returns on fixed income instruments, including bank deposits, which account for over 50 per cent of households’ financial savings. This has already induced a shift to riskier asset classes such as equities, which has ramifications for overall financial stability. The elbow room to stay accommodative then narrows. Given the need for monetary policy to stay accommodative, it might be time to consider other supply-side interventions such as cuts in excise rates on petroleum products to soften the inflation blow.


This column first appeared in the print edition on June 24, 2021 under the title ‘Inflation and its discontent’. Joshi is chief economist and Tandon is economist, CRISIL Limited

First published on: 24-06-2021 at 03:01:58 am
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