How to tame the elephant in the economy
The RBI expects inflation to peak by the quarter ending March, but that may depend on a clutch of imponderables
- By: Neha Bothra
- Published:
- 09/12/2021 02:45 PM
"Price stability remains the cardinal principle for monetary policy. Our motto is to ensure a soft landing that is well timed."
- Shaktikanta Das, RBI governor
This statement reflects the unrest in the minds of most global central bankers as they precariously tackle 'stubborn inflation' and focus on the 'overarching priority at this juncture to broaden the growth impulses’. In this spirit, Reserve Bank of India (RBI) Governor Shaktikanta Das checked all the boxes in his earnest attempt to assure the Street that the central bank would remain 'accommodative as long as necessary to revive and sustain growth on a durable basis', even though 'the monetary policy is reaching an inflection point’.
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Reining in inflation
On the face of it, inflation seems to be aligned with the MPC's target of 4 percent [with a +/- margin of 2 percent]. But many economists are wary of underlying dynamics masking the 'real' inflationary pressure, given the overall composition of the consumer price index (CPI) basket [Exhibit 1]. The cost of 131 out of 293 (or 45 percent) low-weightage items in the CPI basket rose by over 6 percent. So, the headline inflation at 4.5 percent in October could have been higher if not for the recent moderation in food prices (which was largely due to statistical reasons), says Madan Sabnavis, chief economist, Care Ratings.Public finance expert M Govinda Rao, former director, National Institute of Public Finance and Policy, says, "I don't think this is alarming to policymakers yet even though people are suffering. Earlier such high WPI could have posed a huge challenge for governments." Rao is concerned that a high WPI will significantly stoke the inflationary trend if fiscal measures are not deployed to augment supply of raw materials like coal, since a rate cut does not seem to be on the cards for now. On his part, Das put the ball in the government’s court, suggesting a reduction of excise duty and VAT on petrol and diesel to cool inflation.
The growing gap between the CPI and WPI [Exhibit 4] can potentially erode profit margins of small business owners and manufacturers. This can lead to a roll back in production plans and adversely affect economic efficiency, growth and employment. Rising input costs have a spiralling effect and can derail the growth momentum if unchecked. Das alluded to this when he said, "Persistence of high core inflation since June 2020 is an area of policy concern. Input cost pressures could rapidly be transmitted to retail inflation as demand strengthens.”
The big picture
The RBI has retained its GDP and inflation projections at 9.5 percent and 5.3 percent respectively for FY22 [Exhibit 5]. But Aurodeep Nandi, economist and VP at Nomura, believes the central bank's macro view of the economy "somewhat downplays the inherent upside risks on inflation, especially with firms across various sectors starting to raise their prices amid potential demand side pressures that would start to build up as the output gap closes”.However, the RBI MPC has clearly reiterated its stated mission to support growth and 'normalise liquidity conditions when warranted' in a 'non-disruptive way'. Though rising inflation poses a threat to sustainable macro objectives, since economic growth is still not durable [Exhibit 5], the central bank is likely to focus on measures to support growth and not hike rates or change its dovish stance this fiscal, explains Sabnavis.
Importantly, the US Federal Reserve recently signalled a shift in monetary policy to address surging inflation despite the threat posed by the new Covid variant omicron. Should the US Fed taper its balance sheet sooner than expected, there can be fresh challenges for the domestic economy in the form of 'spillovers'. "In such a scenario, domestic macro fundamentals need to be resilient, with appropriate policy stances and actions, and strong buffer," said Das.
After the MPC announced the bi-monthly credit policy, the stock market ended the trading session in the green, with the S&P BSE Sensex closing over 1016 points higher at 58,649.68 points. Most brokerages do not expect the RBI to hike the repo rate this fiscal. “We expect the RBI MPC to turn neutral in April and hike policy repo rate in June 2022,” said BoFA Global Research analysts in a report dated December 8.
Clearly, the focus on nurturing economic recovery overshadows the looming threat of inflation in the background. Worldwide, inflation is no longer seen as a transient pain, yet most central banks, RBI included, are hesitant to err on the hawkish side in this Catch-22 situation. Most economists do not see an alternative monetary policy response to this conundrum either. But they do suggest fiscal measures, such as a cut in high taxes on fuel, to ease the prospect of high inflation and its cascading impact on the economy.
Given the state of the economy, most policymakers see the new coronavirus variant omicron as a bigger source of disruption than inflation, even as they prepare for a ‘soft landing’ in an increasingly volatile economic backdrop. One wonders if this extract from Lewis Carroll’s Alice’s Adventures in Wonderland resonates with central bankers in these perplexing and unprecedented times:
“In that direction,” the Cat said, waving its right paw round, “lives a Hatter: and in that direction,” waving the other paw, “lives a March Hare. Visit either you like: they’re both mad.”