Inflation, monetary policy and growth

What does one make of the fact that households’ inflation expectations have remained at 6% plus levels over the last four years? Does it mean that the Indian economy has been facing persistent excess demand?

There is a divergence between wholesale and retail inflation...

People shop for fish at a market in Kolkata, India. At a time when the economy is in a contraction phase and producers are perhaps sitting with unprecedented levels of idle capacity, households expect inflation to grow in double digits in the future. (AP)

Consumer Price Index (CPI), India’s benchmark inflation measure, grew at 6.9% in the month of July. Headline inflation has been growing at more than 6%, the upper limit of RBI’s tolerance level, since December 2019. March was the only exception. India’s other inflation measure, Wholesale Price Index (WPI), has been contracting since April 2020. (See Chart 1)

To be sure, this is not the first instance of divergence between the two inflation measures. A 2015 Mint story by this author pointed out that there have been four such instances since 1982-83. The divergence between the CPI and WPI is not surprising as they differ in composition. Food items have a share of almost 40% in the CPI basket. This is just 24% for WPI. Therefore food price hikes generate stronger tailwinds for CPI. But the food components of CPI and WPI actually move very closely with each other. (See Chart 2)

... that isn’t entirely explained by the weightage to food.

Difference in the weightage of food items is not the only reason for divergence in CPI and WPI. A comparison of non-food components of CPI and WPI brings out this fact clearly. (Chart 3)

This too is understandable. WPI is focused on capturing producer costs, while CPI is representative of the average consumer basket of an Indian household. The CPI basket is decided after the National Statistical Office’s consumption expenditure surveys. CPI has components such as housing and recreation. WPI has crude petroleum and engineering goods.

Inflation expectations of households are still high ...

Inflation expectations of households have come down compared to what they were six-seven years ago. But they continue to be significantly above RBI’s upper band of 6%. RBI data also shows that trajectory of current and future inflation expectation for households has been almost identical in India. (See Chart 4)

What does one make of the fact that households’ inflation expectations have remained at 6% plus levels over the last four years? Does it mean that the Indian economy has been facing persistent excess demand?

... But this does not mean there is excess demand.

Policy moves required

At a macro level, inflation indices are not constructed for the sake of it. They are of fundamental importance in accessing the state of an economy at any given point of time. A rise in inflation is inferred as an indication of emerging supply side constraints. Deflation, on the other hand, suggests a collapse in demand.

These situations require different policy interventions. A demand shock is needed when inflation starts rising. This could be in the form of an interest rate hike, or rationing. A deflationary economy will need a stimulus. This could be given via direct cash transfers, or a cut in interest rates, which would then lower the cost of consumption and investment, the two key constituents of aggregate demand. It is this theoretical framework which guides India’s monetary policy framework.

The RBI is mandated to use policy rates to achieve a balance between growth rate and inflation.

RBI’s inflation targeting framework looks at various parameters such as aggregate demand, monetary transmission (link between policy rates and retail lending rates), and inflation expectations. There a debate on the choice of the nominal anchor when the inflation targeting framework was being adopted.

The Expert Committee to Revise and Strengthen the Monetary Policy Framework chaired by the then deputy governor Urjit Patel — it laid the basis of the inflation targeting framework — opted for headline CPI. But interest rates, which are what RBI uses to balance inflation and growth, can hardly be expected to influence food prices. Food items have a 40% share in the CPI basket. This issue was raised to object to the choice of CPI as the nominal anchor. The committee justified the choice on the grounds that it “closely reflected the cost of living and influences inflation expectations relative to other available metrics”.

The economy had been losing growth momentum even before the pandemic disrupted economic activity. The GDP growth rate fell from 8.3% in 2016-17 to 7%, 6.1% and 4.2% in 2017-18, 2018-19 and 2019-20. Private consumption, which accounts for more than half of India’s GDP, grew at 5.3% in 2019-20, the slowest since 2009-10. The economy has been facing deficient rather than excess demand.

This is corroborated by a comparison of the manufacturing component of WPI with capacity utilisation levels. The latter is considered to be a good proxy of demand in the economy. The former can be considered as a good proxy of market conditions facing manufacturing firms in India. When demand is weak, producers are expected to suffer a dent in their margins. A market with strong demand sees the burden of increased prices being shifted to consumers. Both capacity utilisation levels and WPI manufacturing have been falling for quite some time. This suggests that the Indian economy has been facing a deficient demand. The lockdown must have made matters worse on this front. (See Chart 5)

... and that is the challenge facing RBI. This is the centrality of economic policy challenge in India. At a time when the economy is in a contraction phase and producers are perhaps sitting with unprecedented levels of idle capacity, households expect inflation to grow in double digits in the future.

The purpose of this discussion is to highlight a problem in interpreting headline inflation numbers as a metric of overall demand-supply conditions in the economy. One interesting question is worth asking. What if, there were a comprehensive food security programme in India, which would also provide fixed quantities of vegetables, edible oil and pulses along with rice and wheat? If food price worries were not to affect inflation expectations, maybe they would better capture the dynamics in the non-food economy, which accounts for more than 80% of the Gross Value Added.