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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.