Banking Central | Government, RBI's inflation battle is a double-edged sword

File image of FM Nirmala Sitharaman.

The government over the weekend announced a string of measures, including fuel duty cuts, additional support for farmers and lowering of import duties, to cool soaring prices.

Moneycontrol in a series of stories has been writing about how inflation has hit every segment—from household budgets to big businesses—hard. We also wrote that the government would likely step in to check inflation and that is what happened on May 21.

The government cut the central excise duty on petrol by Rs 8 a litre and on diesel by Rs 6 a litre. It also waived customs duty on the import of some raw materials, including coking coal and ferronickel, used by the steel industry. To improve availability, it hiked the duty on iron ore exports by up to 50 percent and a few steel intermediaries to 15 percent.

The measures are likely to have a favourable impact. According to Radhika Rao, senior economist at DBS, the excise duties cut on petrol and diesel would potentially lower inflation by 0.2-0.3 percent and is likely to reflect in June’s reading. That’s the good news.

These steps show the government is concerned about galloping prices and looking for ways to cushion the blow brought about by a spike in commodity prices, disruption in global supply chains and abundant liquidity.

High prices have forced households to cut back discretionary spending, or spending on non-essential items, which will impact demand for goods and services, translating to lower economic growth.

But at this stage neither the government nor the Reserve Bank of India seems too worried about growth—inflation is the biggest concern.

There is more bad news this year.

In a note released on May 23, Moody’s said heatwaves could add to the inflation woes. “The prolonged high temperatures, which are affecting much of the northwest of the country, will curb wheat production and could lead to extended power outages, exacerbating already high inflation and hurting growth,” it said.

The government’s fiscal measures follow the May 4 rate action where the central bank hiked the key repo rate by 40 basis points (bps) and the cash reserve ratio (CRR) by 50 bps.

Repo is the rate at which the RBI lends short-term funds to banks, while CRR is the mandatory portion of deposits banks need to park with the RBI on which they earn no interest.

RBI’s turn now

As far as the inflation fight goes, the next round will likely come from the RBI in the form of another rate hike.

In the monetary policy committee meeting minutes released recently, member Jayanth Varma said another 100 bps rate hike was warranted. Later in an interview to Moneycontrol on May 19, Varma said this should happen “very soon”.

For policymakers, however, taming inflation is a double-edged sword. The steps to curb inflation will have side effects on the economy.

One, a sharp rate hike in a short period can shock the credit markets, spiking credit costs for everyone, hitting small companies particularly hard and adding to the burden of individual borrowers. Overall lending rates will go up, making bank money costly for everyone.

Two, bond markets will feel the heat. The duty cuts and subsidies announced by the government will significantly add to its borrowing costs, pushing it to borrow more from the market. This will, in turn, push the bond yields high.

Three, the fiscal deficit will broaden. According to Barclays’ analysts, the measures mean that the overall fiscal deficit will likely exceed budgetary estimates by at least Rs 2 lakh crore. “We revise up our fiscal deficit for FY22-23 to 6.9 percent, from government budget estimate of 6.4 percent,” the analysts said.

Also read: RBI board approves transfer of Rs 30,307 crore as dividend to government for this fiscal

Coupled with a lower-than-expected dividend from the RBI, the fiscal pressure on the government has mounted. This would mean an overall incremental fiscal shortfall of Rs 4 lakh crore for the government, Barclays’ said.

In inflation sweepstakes, there are no clear winners.

(Banking Central is a weekly column that keeps a close watch and connects the dots about the sector's most important events for readers.)