Ignoring it for long could increase longer-term costs
The latest inflation data has put the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) in a spot. The consumer price index-based inflation rate increased to a six-month high of 6.3 per cent in May, surpassing the upper end of the central bank’s tolerance band. The pickup in prices is fairly broad-based and should worry the central bank. While the food price index increased by 5 per cent, the fuel and light component went up by 11.6 per cent. But the momentum was not driven only by food and fuel components. Core consumer price inflation increased to a near seven-year high of 6.6 per cent. The inflation rate based on the wholesale price index also increased to 12.94 per cent in May.
Economists expect the inflation rate to remain elevated in the near term, which will significantly complicate policy choices of the Indian central bank. The RBI is focused on supporting growth and seems willing to tolerate inflation to an extent. Its latest projections show that the MPC expects inflation to average 5.1 per cent in the current fiscal year. This will warrant a further upward revision, and ignoring inflation risks will become far more difficult for the rate-setting committee. Over the last few quarters, it has been maintaining that higher inflation is largely emanating from supply chain disruptions and will ease with improvement in economic activity. But supply chain disruptions during the second wave were much lower than in the initial phase of lockdown in 2020. While it is possible that prices will ease somewhat as supply improves, the inflation rate is likely to remain significantly above the target of 4 per cent in the foreseeable future.
This means the policy rate in real terms will remain in negative territory for an extended period. The RBI is currently focused on supporting growth by keeping market interest rates low, which is also helping the government finance its deficit. Consequently, it has flooded the system with liquidity and committed to doing more to support growth. In the current economic situation, policy focus on reviving growth is understandable, but it is worth debating at what point the central bank should shift its focus to inflation conditions. Real negative interest rates for far too long will also affect household financial savings with wider macroeconomic implications, including the cost of money.
To be sure, India is not the only country facing inflationary pressures. The inflation rate in the US has climbed to a nearly 13-year high of 5 per cent and the producer price index in China has risen by 9 per cent — the highest since 2008. The US Federal Reserve is of the view that higher inflation is transitory, but there are concerns that the US central bank might fall behind the curve, which would result in abrupt policy tightening. Inflation is being largely driven by pent-up demand and higher commodity prices. But the US Fed is in a comparatively comfortable position with well-anchored expectations and a history of low inflation, which gives it the leeway to tolerate higher inflation to support growth for a while. The RBI doesn’t have similar freedom. Thus, it remains to be seen how the RBI will persuade markets about price stability while supporting growth. One way out would be to start reducing liquidity and allowing yields to move up. Ignoring inflation risk for long could increase longer-term economic costs.