India’s Inflation Conundrum: Implications and Concerns about RBI Stance

Synopsis

The recently formed monetary policy committee has announced to maintain status-quo and possible repo rate cuts in the upcoming months. The committee also expects the inflation to fall in bandwidth set by RBI in the second half of the financial year. After missing the inflation target in the last few months, RBI has acknowledged the supply-side shocks for rising food inflation. The MPC redefining their role is positive but there are still growing concerns about the agriculture sector after dissecting the food inflation. While the RBI sends a strong message of addressing liquidity concerns there exist multiple other challenges. The current measure taken might be a necessary but not sufficient condition for the economy to move forward. The complexity of inflation is a fault line that cannot be changed by shifting regime but needs concerted effort between Centre and RBI.


Inflation hit an eight-month high of 7.34% in September, way above the target limit of 2-6 % set by the Reserve Bank of India (RBI). Unable to tame the inflation in the past few quarters, the monetary policy committee (MPC) is expecting the growth to contract by 9.5% in FY21. Prioritizing the growth recovery, RBI has spelled out to maintain an ‘accommodative’ stance-lowering rates to inject money into the system. Since the lockdown, the RBI has slashed the repo rate by 115 basis points to support growth while keeping rates unchanged this quarter. Additionally,  they sought to undertake open market operations (OMOs) by buying state government bonds to the tune of INR 20,000 crores. The first of a kind measure is set to mollify the discontent between states and centre over the compensation of Goods and Services Tax (GST).  The RBI also announced a slew of measures to let banks hold higher statutory liquidity ratio (SLR) till the maturity of securities and targeted funds to specific sectors for averting risk in the financial market. 

Experts believe the current measures are aimed to address the liquidity concerns, however, in these pandemic times, the puzzle of rising inflation remains. Under the assumption that there is excess cash flow, monetary policy is being constrained by slashing interest rates. Nonetheless, the current scenario dictates that it would be an erroneous decision to curb inflation by merely deploying monetary policy.

Two noteworthy points to be studied here are;
The role of the MPC in a possible situation of the trilemma– a tradeoff among central bank’s autonomy, capital mobility, and exchange rates; and, diagnosing the possible factors that could explain India’s inflation problem and ways to address the same.

In 2016, RBI officially formed the MPC to have flexible inflation targeting regime (ITR)– an official agreement to moderate inflation between 2-6%. Breaking the vow even before the pandemic the headline inflation stood at 7.59% in December 2019. With MPC tenure ending in 2021, there are debates on the role of the central bank and the effectiveness of the inflation targeting regime. Previously, RBI adopted a multiple-indicator approach that considers various macroeconomic and financial variables for monetary policy. Moving away from the old model, inflation stability has become the primary objective of  RBI but ideal objectives need revision at the time of the pandemic.

New Zealand was the first country to adopt the ITR in the 1990s, both country-specific and cross country analysis gave mixed results on the long term effect of the framework.  Studies on the impact of countries adopting ITR have contrasting conclusions for developed and developing countries.  While the developed economies controlled inflation and increased growth volatility, emerging economies had more welfare gains and built resilience to deal with shocks. However, one of the prominent criticisms against the regime has been the instability caused by the exchange rates. In effect, the choice for the central bank under the ITR model has always been between ensuring controlled inflation and financial stability. 

The much-discussed ‘impossible trinity’ or trilemma proposed by Mundell-Fleming has returned to academic literature when central banks started redefining their roles post-liberalization. The trilemma has been observed admitting the trade-off among the central bank’s independence, stability exchange rate, and capital mobility. A latest empirical study suggests the trilemma in the context of India is a quadrilemma. Financial instability arising out of increasing short-term capital inflows is considered the fourth dimension of the macroeconomics and policy trade-off. Also, capital mobility has increased in India at the cost of exchange rate stability. Managing the foreign exchange (FOREX) reserve effectively is considered a suitable policy measure to navigate the quadrilemma situation. 

The forex reserves of India are at an all-time high of $542.013 billion, the escalated reserve serves as a blessing in disguise for the economy. However, a hefty portion of our foreign currency reserves is not long term incorporations but short-lived increments. The rise in net foreign direct investments (FDI) by $301 billion and $141 billion in foreign portfolio investments (FPI) and import bills saved because of a fall in global crude oil price. 

Through market intervention, the RBI managed to secure 125 billion USD of foreign currency.  The central bank by piling up forex reserves allowed the rupee to appreciate to control inflation– the rupee gained around 2.7 % against the dollar. Letting the rupee become strong de facto is constraining monetary conditions by making the terms of trade against India. Moreover, for every 5% appreciation of the rupee inflation barely reduces by 0.2 %. To sum up, India’s external balance carries the weight of systemic imbalance. International investment hardly materialized into an increase in output and employment in India. Given the situation, it is justified to expect RBI to take up a more versatile position to ensure stability in the rupee and translate the short-term gains into meaningful investments. 

Finding the Causes of Inflation

In the wake of the pandemic, the Organization of Economic Cooperation and Development (OECD) countries faced a severe contraction in demand leading to deflationary pressure. Depressing global oil prices and stocks piling up due to poor consumer demand with rising unemployment caused the general price level to fall leading to global deflation.

India’s economic crisis during the pandemic exposed multiple structural issues prevailing in the economy. There was a significant growth stagnation during this period steered by inadequate investments in the recent past. As per the World Bank data, gross fixed capital formation (or investments) stood at 28.6% in FY18 and 29.3% in FY19 which shows no growth in the past year. Along with the dwindling investments, the badly hit exports due to the global trade conflicts declined at 6.1 percent during September’19 were recognized as the major reason behind the sluggish economic situation and declining demand. 

Headline inflation measures as Consumer Price Index (CPI) are primarily driven by food and fuel prices. Many experts question the inflation target regime due to the methodological limitation and higher weightage given to food. Even before the lockdown, the volatility in food prices has been a concern in India.

Food constitutes the biggest portion in the consumer basket, the demand always outstripped the supply.

Rather, the supply never levelled up to meet the growing demand hence causing cost-push inflation. The CPI calculation assigns a maximum weight of 54.18 % to food and 7.96 % to fuel and light.  It is possible to conclude, severe fluctuations in food prices could have led to inflationary pressure. However, the core inflation that excludes the temporary shocks in prices stood at 5.8% in August and remained above 4% for the past five months. At this juncture, an upward trend in both headline and core inflation calls for a revision of the ambitious targets set by the central bank in the lights of growth recovery. 

The RBI was essentially tasked to focus on inflation levels by adopting a gradualist approach- toolkit used by the central bank since the 1991 reforms. The currency in circulation has accelerated to 21.3 % in June from 11.3% in February. The tightening of the monetary policy usually assumes an imperative of excess money among the public. Undoubtedly, cash in hand ought to accumulate during the time of lockdown due to uncertain economic conditions. An increase in the money supply is a short-term shock but the gripping reality of unemployment, low income, and closure of the small business is the real concern for growth. The coal, steel, and electricity showed a major slump exposing the significant risk faced by the manufacturing sector. Only the agriculture sector recorded a positive growth rate of 3.4 %– farming activities that were considered essential with almost no restrictions. 

Breaking Down the Food Inflation

 India has an impressive record of food stock– around 728 lakh metric tonnes of food grains in April. Anyone with basic knowledge of economics would question why there is a rise in food prices when there is no shortage of supply? If India is following the global trend of low demand, subsequently the prices should be theoretically falling. An inchoate supply chain with bottlenecks across the channel explains the puzzle of rising food prices. The food economy in India is largely sourced from peri-urban and rural hinterlands and mostly consumed by the urban population. Non-food grain with the highest weightage within food inflation constitutes 80% of total consumption. Intuitively, the food supply chain (FSC) becomes the lifeline to support the integration of rural-urban markets. Almost 96% of the total FSC is private and largely dominated by small-medium enterprises supplying between 72% to 83% of total food consumed. Supply-side disruption is an evident cause of food inflation in the case of India. In contrast to this assertion, a recent report has observed a strong recovery in the food supply chain in India.  However, the framework of the study is limited to just the lockdown period and partially ignores the already existing supply-side flaws. 

As a supply-side boost, the  Ministry of Finance announced a series of measures to help the Medium and Small Scale Industries (MSMEs) by providing Emergency Credit Line Guarantee Scheme (ECLGS). Around 50.7 lakh business units were covered to disburse a loan sum of INR 3 lakh crore. According to the data collected by Crediwatch (financial intelligence), only 53% of the beneficiaries availed the credit. The scheme by design only caters to the top 3% of the MSMEs receiving up to 40% of the total credit. Only businesses with institution credit access are eligible to avail of the loan– restricting a large number of micro business units.

The recent moves by RBI after the formation of a new MPC panel hints the admission of supply-side shock and growth to be prioritized over inflation. However, there is a lack of clarity if the central bank is willing to bolster the fiscal stimulus package by taking supply focused measures. The recent affidavit filed by RBI denied the extension of the loan moratorium period beyond six months and relief to COVID hit sectors.

After missing the inflation target, the RBI has taken bold steps to sideline inflation targets and focus on growth. However, the economy is a piece of unseemingly complex machinery recovering from a crisis that requires a multi-pronged strategy.

It is still a matter of concern if a substantial sum of money is chasing only a few assets and providing relief to only a few sectors. 

The demand is expected to recover as the lockdown is eased across the country but the inflation will continue to increase if the supply does recover at the same rate of demand. MPC’s role to rekindle growth cannot ignore the gaps in supply-side measures, especially in the agriculture sector swelling the headline inflation. To boost liquidity for the business and infuse cash to stimulate demand, both the monetary and fiscal policy matrix is inevitable.  The second round of stimulus package is expected to spur consumer demand, a necessary but not sufficient policy measure. A concomitant monetary policy focused on removing the residuals of supply-side shock must be considered by the newly formed MPC. The balancing act between maintaining the exchange rate, allowing capital inflows, and the central bank exercising independence requires a strong fiscal measure. In addition to the impossible trinity, India also runs a risk of letting a few businesses benefit through trade competition. The political decision has impetus on the macroeconomic efficiency, India’s aspiration to adopt a protectionist model the atmanirbhar tag by rising exports might have a large effect on the rupee and marginal effect on inflation. 

While officially controlling inflation need not be a target for RBI, undertaking medium-term measures would stabilize the core inflation. Further, targeted liquidity boost for agriculture and MSMEs would support supply-side recovery. Inflation has to be critically viewed as an indicator exposing the structural problems of the economy rather than a numerical number, instilling fear among the public. 

The author was given initial inputs by Ananya Consul.

Further Readings

https://www.researchgate.net/publication/342687340_India_facing_the_macroeconomic_policy_trade-off_-_is_it_dilemma_trilemma_or_quadrilemma

https://www.newindianexpress.com/lifestyle/books/2020/sep/24/quest-for-restoring-financial-stability-in-indiamore-things-change-more-they-remain-the-same-2201446.html

https://www.nber.org/papers/w6545

https://www.nber.org/chapters/c9561

Manjari Balu
Economics enthusiast and a coffee lover aspiring to build a network of like minded thinkers across the world.