A day after RBI Governor Raghuram Rajan announced, during the scheduled monetary policy review, that he would wait and watch how inflation unfolds before taking a call on further interest rate cuts, came an RBI survey that showed that retail consumers expect prices to harden further. According to the December round of the Inflation Expectations Survey of Households, “the proportion of respondents expecting price rise by ‘more than current rate’ for prices in general as well as prices in all product groups (except cost of services) have decreased marginally as compared with previous round of survey [September 2015] for both three-month ahead period and one-year ahead period… However, proportion of respondents expecting price rise by ‘similar to current rate’ for prices in general as well as prices in all product groups has increased as compared with previous round of survey for both three-month ahead period and one-year ahead period.” Significantly, since December 2014, the trend of such household surveys shows a secular hardening of inflation expectations. For instance, mean one-year ahead inflation expectations have gone up from 9.3 per cent in December 2014 to 11.2 per cent in December 2015.
Though not the sole or overriding variable on which the RBI bases its decision, households’ inflation expectations provide useful directional information on near-term inflationary pressures. Higher inflation expectations affect people’s behaviour accordingly and, in general, lead to central bankers raising interest rates. But higher rates are not the ideal prescription for India as it is trying to ramp up investment. In fact, while the government has been trying to launch one scheme after another to incentivise investment and business activity, the data throws up a rather worrying picture. According to Care Ratings, in the first eight months of the current financial year, the value of new investments announced fell by a massive 32 per cent. “This decline was witnessed across both the government and private sector.”
To put it in perspective, the reduced investments have come after a 125 basis point rate cut in 2015. The feeble transmission (just about 50 per cent) of rate cuts further shows that interest rates are not the only variable holding back growth recovery in India. However, under the circumstances, rising interest rates are a sure-shot recipe for disaster. In the post-policy conference, Rajan said, “inflation is inertial”. That essentially means active steps need to be taken to bring it down because it is unlikely to come down on its own. “Most important of all is the budget as well as the implementation of the Pay Commission recommendation,” Rajan also said. Two aspects are critical in this context. One, if the government introduces the pay commission award, then it must offset it by reducing expenditure somewhere else. Two, the budget must introduce the structural reforms that propel growth.