It is difficult to comprehend a situation in which we confront inflation outside food—the so-called “core inflation”. The narrative about food inflation being the key driver of persistently high headline inflation over the last decade has been so overwhelming that many find it counter-intuitive to see core inflation being above headline inflation and threatening macroeconomic stability. Some continue to believe any alarm is uncalled for and that a large portion of this increase in core inflation is merely statistical or a fallout of one-time policy action; hence, it is unlikely to sustain.
In “Has core inflation begun to feed itself?” (goo.gl/egvdtf), we made the case that room for any delay in raising the policy rate was exhausted, the argument being persistently high inflationary expectations—above 7%—might have been feeding into core inflation, resulting in a slow-moving spiral. The sharp rise in RBI’s households’ inflationary expectations (one-year ahead) in the May 2018 round—close to double-digit, 9.9%—even as food inflation remained subdued, corroborated apprehension that a different set of dynamics are unfolding in setting core inflation.
Since the inflation-targeting framework works on the principle of anchoring expectations, it was expected the MPC must send an unambiguous signal to arrest expectations from shooting above the double-digit mark. A reversal in the interest rate cycle was thus inevitable. It was not surprising then that the MPC raised the repo rate by 25 bps in last week’s monetary policy review. But by retaining the “neutral stance”, the message seems to have been diluted to a large extent.
We know all six members voted for a rate hike, but what led the “doves” in the committee to side with the “hawks”? Was the decision to retain the neutral stance unanimous too, i.e., all members felt there was fair amount of uncertainty on inflation projections, as Governor Urjit Patel said in the post-policy interaction with media? Or “doves” outnumbered “hawks” in restraining a change in policy stance to tightening? What actually transpired in the three days of extended deliberations would be of greater interest, but more details will be known on publication of the meeting minutes on June 20 Nonetheless, the decision to preserve the neutral stance has confused many—the MPC is perceived as saying that though it has raised the FY19 inflation forecast by 30 bps and flagged some upside risks, there are still possibilities for a downside inflation surprise. Most have completely discounted this, many have incorporated either one or even two more hikes in FY19 in their post-policy briefs.
RBI’s own macro-diagnostics, detailed in the policy statement, don’t quite support this relatively dovish stance. Key elements are: (i) domestic economic activity has exhibited sustained revival in recent quarters and output gap has almost closed; (ii) GDP growth for 2018-19 will accelerate to 7.4%; (iii) with improving capacity utilisation and credit offtake, investment activity is expected to remain strong; (iv) consumption, rural and urban, remains healthy and is expected to further strengthen; (v) farm inputs and industrial raw material costs have risen sequentially; (vi) wage pressures in organised sectors remained firm, but moderated in the rural sector; and (vii) significant rise in households’ inflation expectations could feed into wages and input costs ahead. Even though many of these statements carry caveats, it is hard to see what else could have led the MPC to believe that core inflation could lose momentum going forward!
There is nothing but the possibility of ultra-low food inflation sustaining due to a normal monsoon. But monsoons could always surprise, spatially and/or temporally. The MPC elaborates that the impact of MSP formula revisions for kharif crops is not possible to assess at this stage for lack of adequate details. But even in its absence, the political economy of food is telling us the compulsions to boost farm prices, e.g., the spate of hefty import tariffs on pulses, wheat and some other products, the ‘sugar’ package instituting a benchmark MSP.
Thus, with growth accelerating and output gap closing, inflation expectations shooting up, input prices rising, and a political economy (in an election year) overwhelmingly tilted in favour of uplifting farm prices, where is the downward risk? Amid oil prices firming up, weakening rupee and tightening global financial conditions, there wasn’t any convincing case for the MPC to stay neutral. While advanced economies fighting low inflation have the luxury and space to let their monetary policies be data-driven, emerging economies can hardly afford to let expectations drift in a highly volatile environment. If core inflation momentum picks up further in the next two prints (May and June 2018), it could potentially dent MPC’s credibility.
It is quite possible that “doves” in the committee worry about the budding recovery in progress and would like to stay put for some more time. Contrary to the policy statement, they may have felt that consumer demand has actually slowed, private investment is yet to strike roots—hence, a hawkish stance could prematurely rock the boat. Such a view may not be out of place: Despite the robust quarterly GDP growth of last two quarters, economic activities continue to be fragile. Why else, for example, does the services’ PMI representing more than 60% of GDP periodically relapse into contraction territory?
But, in inflation-targeting, the management of expectations takes primacy over growth concerns. The underlying supposition is that until expectations have been conditioned closer to the medium-term target, 4%, a durable victory over inflation cannot be considered achieved. RBI, however, has been taking a more nuanced view that focuses more on the direction than the level of expectations. Therefore, we felt that both direction and magnitude of inflation expectations in the May survey ought to have alerted the MPC!
It is not clear what contributes to households’ inflation expectations. In the previous inflation bout, some research guided us that food inflation was the trigger. We were also told that if private consumption growth sustains much above agriculture growth, food inflation would persist above headline inflation. But nothing of that sort has happened. Econometric models claimed expectations in India are backward-looking—but the sustained, ultra-low food inflation did not result in any collapse in inflation expectations either!
So now, it is up to the MPC to figure out if expectations this time round are forward-looking—triggered by a weakening rupee, government policy decisions to affect full oil-price pass-through, promise to raise MSPs, willingness to raise tariffs to protect domestic industry and consciously going soft on fiscal consolidation. But at no cost should the MPC let expectations fall into the “double-digit trap.”
Concluding on a sombre note, we have to say that output sacrificed in the last round of monetary tightening was, to a large extent, mitigated by the oil-price windfall. But this time round, there would be no such luck because the rise in domestic retail oil prices itself could be one of the triggers. Having chosen the path, growth concerns should not deter the MPC from traversing the right course.
The author is a New Delhi-based economist.