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Between inflation and growth, the latter remains taller risk

Although inflation remains above the RBI’s upper band, and core inflation firms around 6 percent, the high energy costs and pandemic-related forces are dominant drivers 

July 16, 2021 / 12:13 PM IST

The June inflation data showed annual retail price growth steady at 6.26 percent versus 6.3 percent in May. This takes off pressures upon the central bank, which was battling apprehensions of higher inflation risks soon after its June 4 review.

An overwhelming 207 basis point monthly jump in May increased interest rate futures at least 20-30 basis points with no signs of abatement and in widening inconsistency with the bond market. Signals in the latter were suppressed by the RBI’s efforts to cap the 10-year benchmark (now the old one since July 9) yield at 6 percent. This had become glaring, pushed out buyers.

Before the June inflation outturn, the central bank had moved to redress the situation: One, in an interview to a daily newspaper, the Reserve Bank of India (RBI) Governor tried steering markets to the view that the surge in inflation was fleeting and regain command over the inflation narrative. Two, this was followed with issuance of the new 10-year benchmark bond at 6.10 percent to get buyers back into the market. The subsequent bond auction went off without devolving after several months while the older (5.85 percent) 10-year benchmark yield has traded 10 basis points higher with the freedom.

The RBI’s fresh flexibility and overtures, however, do not break any new ground on monetary policy. Although inflation remains above the RBI’s upper-band, and core inflation firm around 6 percent (softening from May’s 6.6 percent), the push is dominated by high energy costs and pandemic-related forces. The critical judgment is about its transitory nature and how long this could persist. This perplexity is global.

Assessing inflation has become uncertain business because COVID has upended not just supplies but also demand - the former, by disruptions and structural changes, and the latter through a mixture of suppression-cum-bounce back, lost incomes and jobs, policy support props, to name some.

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Policymakers worldwide are severely challenged as result. Disaggregating these effects is a common problem for central banks. For the RBI, this is less of a problem. Demand readings are a fairly straightforward decider: India’s post-reopening rebound is nowhere as linear and broad as in countries with superior fiscal stimulus during COVID-19; its weak state or disinflationary force should eventually outrun the supply-side induced inflation.

The post-reopening indication is of a hesitant recovery. On the positive side is the much lower sequential decline in industrial output growth due to the lockdown this May than one year ago; buoyant export growth due to sharp growth turnarounds in the advanced nations and China — 18 percent corresponding growth in merchandise exports in April-June over 2019; business activities restoring to near pre-pandemic levels in June, among some.

These are countered by some worrying setbacks: the surprising fall in June PMIs — to 48.1 in manufacturing from 50.8 in May, to 41.2 in services (versus 46.4), and the composite to 43.1 (48.1 in May) from low demand and business closures; lower GST e-way bills in the first week of July compared to June. Add to these the poor portents of pandemic control, viz. the flagging vaccination rate, potential recurrence or third-wave signs in some states. The readings are still uneven, compelling a weightier inclination towards growth.

Global developments that are likely to be material for monetary policy are two. These need to be watched out for ahead. The first of these is US inflation and monetary policy. Any change in the Federal Reserve’s interpretation of the nature and duration of inflation — this remains ‘transitory’ with energy costs and pandemic-related services as the major drivers — with accompanying reset, including scaling back of the asset purchases, will be of major significance for emerging market economies including India.

The second is China’s recovery. There is considerable uncertainty about this despite a resilient 1.3 percent quarter-on-quarter increase in GDP in April-June. There is caution about an unbalanced recovery even though the 6 percent goal for this year’s growth is likely to be achieved. After a surprise reduction in banks’ reserve requirements by its central bank last week, analysts expect more policy support.

Any easing of interest rates by China and the renminbi weakening would be of global importance — a deflationary force. India is also exposed through exports that are hoped to be a major driver of its rebound at a time when domestic demand is depressed.

In all, the inflation and growth trade-off remains intact as it was two months ago even as the former needs careful handling – from government side as RBI has again underlined - and assessment. The flexibility in the bond market was needed for specific reasons. It is not a guide to future steps in monetary policy. We need to worry more about growth than inflation.

Renu Kohli is a New Delhi-based macroeconomist. Views are personal.
Renu Kohli is a New Delhi-based macroeconomist. Views are personal.

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