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India's Inflation Problem

Retail inflation, as captured by the Consumer Price Index (CPI), has hit a new peak at 6.9% in July, breaching the RBI’s primary goal of keeping inflation between 2% and 6%. This spike is largely led by rising food prices, as food makes up the largest item in the CPI bucket. The Consumer Food Price Index too touched a whopping 9.6% for the period.


What is causing high inflation?

*Source: RBI’s Survey of Professional Forecasters on Macroeconomic Indicators

**Source: RBI’s Inflation Expectations Survey of Households (IESH)


In addition to the above, supply shocks caused by sudden lockdowns also caused a steep increase in prices of essentials, making our situation starkly different from the deflationary conditions emerging in other economies.


The sky's the limit. And that is a problem.


Some level of inflation is considered healthy as it provides impetus to growth. However, high and unpredictable levels of inflation hamper price stability, which can lead to reduction in demand, in turn leading to a fall in output. This is why rising inflation in a falling demand environment is deeply problematic. Different predictions expect India’s GDP to contract by 5-10% in the current fiscal. If high inflation persists in a contractionary environment, we are looking at a classic recipe for stagflation.


Apart from the obvious challenges of high unemployment and the poor being the hardest hit by high food prices, inflation spiralling out of control can have serious second order implications for the whole economy. There has been significant debate in recent days around revising the weightage of food in the consumption basket, given its impact on RBI’s inflation target, which in turn, is a key input in determining interest rates. The higher the rates, the more difficult it is to mobilize funds towards investments.


So why did the MPC decide against reducing rates?


The relationship between monetary policy and inflation is not very clear during times of crisis. Central banks can do little to handle supply shock induced inflation until it starts to get baked into general inflation expectations. To make things worse, easing monetary policy can even turn out to be counterproductive.


It is important to note that inflation has been above RBI’s upper bound target of 6% since December 2019 (with the exception of March 2020). Growth had been decelerating over the last eight quarters and RBI has maintained a very accommodating stance throughout this period. Add to this the certainty of contraction in 2020. With this picture, RBI has no one clear path to proceed with. It could either continue to prolong the stimulus, hard as it is with the little firepower left in fiscal capacity and rising NPAs, or slowly start reverting the rate cuts. As uncertainty begins to subside, the monetary authority will be better positioned to take this call.


The good news is that the supply chains have largely recovered - e-way bill receipts are inching back closer to March levels and GST collection in July was only 7% lower than the same period last year. If this is any indication of the times to come, we can expect a policy change coming out of the MPC’s October meeting.

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