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Analysis | With CPI inflation at 6.7% in August, CEA Subramanian has got his 'expectation' wrong; MPC has a big dilemma ahead

As the August print shows, the CEA’s “expectation” has clearly gone wrong on the course of retail inflation.

September 15, 2020 / 09:24 PM IST

In February this year, Chief Economic Advisor Krishnamurthy Subramanian had said he expects CPI-based inflation to come down to sub-4.5 percent levels by July.

“I expect the headline inflation to converge back to core around July-August. Headline inflation should be around 4.2-4.5. The convergence should happen by July,” Subramanian said.

In August, CPI inflation remained elevated at 6.7 percent, way above the central bank’s comfort zone. The revised figures for the preceding month, too, shows the inflation almost at the same level. With the August print, the CPI inflation has breached the RBIs upper band of 6 per cent for five months.

Clearly, as the August print has shown, the CEA’s “expectation” has gone wrong.

A puzzle for MPC


At a broader level, high inflation and a steep slowdown in growth offers a puzzle for any monetary policy authority. High inflation warrants a tighter policy approach (rate hike) while falling growth requires lower interest rates (rate cut) to boost the economy. At this stage, that’s the situation the MPC is finding itself in. The latest retail inflation print is a worry.

Certainly, elevated inflation will put MPC on a cautious path and could force a prolonged pace, according to economists. “Quite clearly the MPC will keep this number at the back of the mind when evaluating its decision in the next meeting. Inflation is well above the threshold of 6 per cent while growth has slipped quite sharply,” said Madan Sabnavis and Sushant Hede, economists at CARE Ratings. However, there is a view that inflation may not stay high if food prices ease.

“The liquidity situation is comfortable while bank credit growth has been negative. Under these conditions, the decision may steer towards another pause in policy action.”

The MPC, which has cut policy rates by a cumulative 115 basis points in response to COVID, may be nearing the end of the rate cut cycle, a section of economists said. Take a look at the comments by MPC panellists, particularly that of  Michael Patra, in the last MPC minutes.

Patra said, "If inflation persists above the upper tolerance band for one more quarter, monetary policy will be constrained by a mandate to undertake remedial action, including an immediate and more than proportionate response to head off the build-up of inflation pressures and prevent it from getting generalised."

This comment was significant as it highlights that if inflation worries persist, the committee may be forced to reverse its current policy stance and even consider rate hikes.

In its August meet, the MPC left the repo rate unchanged at 4 percent and reverse repo rate at 3.35 percent. Since February 2019, the MPC has cut repo rate by a steep 250 basis points. One bps is one-hundredth of a percentage point.

The bigger question is, can a slowdown-hit, COVID-ravaged economy withstand a tighter monetary policy? Can the MPC afford rate hikes, if that happens when growth is projected to contract as much as 9 percent in FY21?

The growth scenario is worrying. Most analysts expect the Covid-19 impact likely to stay at least till the end of the year. Businesses are unlikely to recover with people staying home fearing infections. With the economic outlook remaining grim, the economy will require a favourable monetary policy response. But, high inflation poses a hurdle for rate cuts.

At best, the MPC could go for another 25 bps rate cut this year given the high inflationary risks. Else, it may stay on a prolonged pause.

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Dinesh Unnikrishnan
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