After the Reserve Bank of India’s (RBI’s) adoption of a flexible inflation targeting framework from August 2016, the rules of monetary policy have changed in India, with the central bank becoming even more focused on anchoring inflation and inflation expectations than ever before. But the COVID-19 pandemic has created a dilemma for the RBI as higher-than-anticipated inflation prints in recent months have compelled the six-member monetary policy committee (MPC) to hold policy rates, even though growth concerns are significantly greater at this stage (the contraction in April-June GDP by 23.9 per cent is testimony to that fact).
The mandate for following an inflation-targeting framework based on one narrow nominal consumer price index (CPI) anchor has highlighted the challenges of conducting monetary policy in a severe growth shock scenario, particularly if it coincides with a sharp increase in headline CPI inflation as in the current period, even if this is mostly due to one-off or/and temporary factors.
While the shift in the monetary policy focus to CPI from the wholesale price index (WPI) has been a welcome development, the current framework has led to an excessive and obsessive emphasis on point CPI estimates, at the cost of ignoring other indicators, in our view. WPI core inflation, which essentially represents the manufacturing sector, is below 1 per cent but this does not find much mention. This is strange because ultimately, the GDP deflator is calculated using both CPI and WPI inflation, with the latter having a greater weight. This should be taken into consideration, in our view, while reviewing the existing monetary policy framework.
Food and beverages constitute 45.86 per cent weight in the CPI basket, while fuel items account for 9.22 per cent, gold and silver 1.19 per cent and tobacco/intoxicants constitute 2.38 per cent. All these are items over which the RBI does not have any control. Given the composition of the current CPI basket, RBI’s monetary policy actions can at best impact only 41.35 per cent of the overall items.
In normal times, a sustained increase in food and fuel prices can lead to a generalised increase in prices. But is this argument valid in the current context where a large number of people have lost their jobs or have seen a sharp fall in incomes due to the adverse impact of the pandemic? If an average family has, say, a Rs 2,000 budget for monthly household expenditure and suppose the same household is now forced to pay higher prices for food and fuel, given the recent increase in prices, will it not be inclined to reduce its consumption of other discretionary items, to keep the budget constant at Rs 2,000? If the answer is yes, then there will be only a relative shift in prices, without any fear of a generalised spiral, as households will not be in any position to demand higher wages to compensate for the increase in prices of food and fuel items. Given the amount of slack in the economy, a scenario of sustained generalised increase in prices seems unlikely over the next 6-9 months.
The CPI inflation targeting framework has helped to reduce inflation expectations during FY17-FY21 on average (9.3 per cent) compared to the previous period of FY12- FY16 (12.8 per cent), but the gap between inflation expectations (which always tend to be higher than actual CPI inflation) and actual CPI inflation has remained unchanged at 5.1 per cent during these two periods. As CPI inflation has fallen in the FY17-FY21 period, inflation expectations have also reduced but the gap between the two has not reduced from the earlier five-year period of high inflation. The success of the inflation-targeting framework should not only be judged by the actual CPI inflation trend, but also in terms of the convergence achieved between actual CPI inflation and inflation expectations.
Even without any formal inflation-targeting framework, India had successfully managed to keep inflation low during FY02-FY06 under the RBI’s earlier stance of using a multiple-indicator approach to conduct monetary policy. It was possible because the increase in minimum support prices of food-grains was kept below 3 per cent on average and the composition of growth was better during this period with investment growth surpassing consumption growth by several percentage points. It is for this reason that CPI inflation remained contained at 4 per cent on average during this period even with 7 per cent real GDP growth.
In the current cycle, investment growth is likely to be impacted more severely than consumption growth, even after the recovery starts gaining traction due to risk aversion, weak profitability and a tendency to preserve cash given the uncertain outlook. Will this lead to a structural increase in inflation, proving the current increase to be a non-transient phenomenon? Given the acute weakness in the demand side of the economy, persistent problems in the real estate sector, continued deleveraging of the NBFC sector and significant job losses (thereby reducing bargaining power for wage growth), we think that risk of a secular increase in inflation is limited.
Given the prevailing unholy mix of growth and inflation, it is tempting to categorise India’s economic situation as one of “stagflation”. But, in our view, it is too early to conclude decisively on this matter, given the fluid nature of things. We still expect inflation to reduce durably from December onwards as supply-side constraints ease gradually and demand-side weaknesses start to manifest.
But what should the policy response be in this kind of a growth-inflation environment? While the scope for rate cuts remains dim in the near-term, we expect the RBI to remain active with a host of unconventional measures, which will likely include more proactive bond purchases to ensure that market interest rates do not rise significantly due to fiscal and market borrowing-related concerns.
This article first appeared in the print edition on October 8, 2020 under the title ‘Rethinking the trade-off’. The writer is India chief economist, Deutsche Bank AG.
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