On inflation, we are not out of the woods

Inflationary pressures are softening but due to global and domestic developments, we can’t be sure it is headed back to RBI’s 4% mandated mark. So let the central bank decide on its policy stance and encourage the government to focus on fostering a climate for investment and growth

The macroeconomic landscape in India has changed suddenly. For most of this year, the main problem was surging prices, which pushed consumer price index (CPI) inflation far above the Reserve Bank of India (RBI)’s target of 4%. In recent months, however, inflation seems to have subsided to some degree. However, there is a new problem: India’s export-led recovery is being threatened by weakening demand in advanced countries, which seem to be slipping into recession. As a result, some analysts have urged RBI to shift its priorities, declaring victory over inflation and focusing instead on reviving growth.

The rupee may remain under pressure in the coming months. As long as inflation in advanced countries remains high, their central banks will need to continue to raise interest rates from historically low levels

At first blush, this shift seems reasonable. But we need to ask two questions. First, is the inflation problem over? And second, if not, what are the costs and benefits of shifting the policy stance?

Let’s understand the first question. Inflationary pressures are indeed softening. CPI inflation was 6.8% in October, down from 7.4% in September. Alongside this, the wholesale price index (WPI) inflation fell to 8.4% from an average of 14.9% in the previous nine months. It remains unclear whether these developments represent the start of a new trend or a temporary low. After all, core (non-food, non-fuel) CPI inflation has been running around 6% for the past three years, implying that inflation has become deeply ingrained at a level higher than RBI’s target.

Moreover, there are still significant risks to the inflation outlook.

First, there has been a substantial spurt in the prices of cereals. Cereal inflation increased from 11.5% in September to 12.1% in October. In particular, rice prices increased by 10% and wheat by more than 17% on a year-on-year basis. These developments are puzzling, considering that the government has been flooding the market for some time with cheap grains under both the Public Distribution System and the Pradhan Mantri Garib Kalyan Anna Yojana free food scheme (launched in March 2020 as a Covid-19 relief measure). The latter provides five kg of free foodgrain (wheat or rice) per person per month for a family holding a ration card and covers a significant portion of the population.

Why are cereal prices going up despite this massive free provision? One possibility could be that the government has used up much of the grains in its stock, and now the stocks are running low. If, on top of this, the winter wheat crop suffers due to the unseasonal October rains, then high cereal inflation could persist, thereby feeding demand for higher wages, which would translate into high general inflation.

Second, global inflation is still not under control. While inflation in the United States has receded to 7.7% in October from 8.2% in September, inflation in the United Kingdom is 11% and rising, and that in the European Union (EU) has increased to 11.5%.

Third, the rupee may remain under pressure in the coming months. As long as inflation in advanced countries remains high, their central banks will need to continue to raise interest rates from their historically low levels. Economists expect the US Federal Reserve to raise its policy rate by another 100-150 basis points. In addition, the Organization of Economic Cooperation and Development has recently indicated that rate hikes in the EU would need to be even larger. These higher rates abroad will continue to discourage the capital inflows that India needs to finance its large and growing current account deficit. This will be problematic for the rupee. A depreciating rupee means that India would be importing the high global inflation.

For all these reasons, international and domestic, we can’t be sure that inflation in India is headed back to 4%. And this leads us to our next big question: Should RBI stay focused on the inflation problem, or should the monetary policy focus on reviving growth?

The main benefit of lowering interest rates is that it would encourage domestic investment. But it is far from clear that investment is being held back by high-interest rates. In fact, private sector investment has been sluggish for the past decade, regardless of whether RBI policy has been tight or stimulative. As a result, it is difficult to believe that another shift in RBI’s policy stance will make much of a difference.

Consider now the potential costs of such a shift. The most obvious cost is that stimulating the economy could worsen the inflation problem. However, the biggest cost is perhaps much more subtle: When analysts urge RBI to try and revive growth, they distract attention from the deeper policy actions that are required on the part of the government, namely the task of creating an economic framework that encourages firms to take risks and expand capacity. As a result, the reforms needed to revive investment are not undertaken.

We are still not out of the woods on inflation. Hence, we should let the central bank do its legally mandated task of bringing inflation down to 4%. And we should encourage the government to focus on its mandate of creating a supportive environment for investment and growth.

Rajeswari Sengupta is an associate professor of economics, Indira Gandhi Institute of Development Research, Mumbai The views expressed are personal