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Target practice

Inflation and industrial production data point to stagflation. RBI must rein in inflation expectations

THE March consumer price index and wholesale price index inflation figures released on Tuesday indicated that the downward trend in inflation has reversed. After falling for three months, wholesale inflation increased from 4.68 per cent in February to 5.7 per cent in March. Similarly, retail inflation, on which monetary policy is now based, increased from 8.03 per cent to 8.31 per cent.

Though the high retail inflation in vegetables and fruit was largely responsible for the increase in headline CPI inflation, core WPI inflation (which excludes food products) is also at a 12-month high. Further, wholesale inflation in manufactured goods has also risen. Read in conjunction with the industrial production data released last week, the economy may be facing a stagflationary crisis.

And contrary to the assertion that the RBI cannot impact retail inflation because monetary policy is not effective in controlling food prices, the central bank can indeed rein in the price rise by dampening inflation expectations.

According to data released last Friday, there was a 1.9 per cent year-on-year fall in the IIP for February on account of the continued sluggishness in the manufacturing sector. It is difficult for Keynesian economics to reconcile the contracting manufacturing sector and complaints of unused capacity with manufacturing inflation. But there is no need to reinvent the wheel —  the US’s experience of stagflation during the 1970s, among other instances, tells us how to deal with it.

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At the time, in the US, inflation was being blamed on the pass-through of the oil-price shocks, and so the US Federal Reserve pursued an unduly loose monetary policy. As a result, high inflationary expectations got deeply entrenched and the Fed lost its credibility as an inflation fighter.

Precisely because of this, when it finally acted to dampen expectations and inflation, it resulted in the deep and painful “Volcker recession”. In India too, there are indications that inflation expectations are high and rising. Only when it is low and stable for a long enough period of time will these expectations moderate. This is where the RBI’s inflation targeting comes in.

The only way to deal with stagflation and nudge the economy back to a high-growth trajectory is to first counter inflation, and thereby, high inflation expectations. It is imperative that the RBI maintain its credibility and keep inflation low, stable. And for those worried about growth, let’s not forget that high inflation is inimical to growth because of the uncertainty it creates.