In a recently published academic paper, former Federal Reserve Chairman Ben Bernanke and former International Monetary Fund chief economist Olivier Blanchard have shown that the sharp rise in US inflation after 2021 was caused by a mix of rise in demand (due to government and Fed stimulus) and fall in supply (due to shortages of goods). The post-pandemic price rise in India can be explained by similar demand and supply factors. Supply shortages due to global supply chain disruptions have been a cost factor everywhere. As for the stimulus, even though the fiscal package was smaller in India than in the US (where the government debt is close to breaching the legal limit), the recovery in economic activity here has been stronger, keeping average consumer price index (CPI) inflation at 6.5 percent over the past year. However, the comparison with the US ends there.
Labour Market Pangs
The Bernanke-Blanchard paper argues that wage inflation is a growing concern as workers are demanding higher wages to compensate for rising costs of living and hence the Fed is advised to cool off the overheated labour market – a euphemism for keeping liquidity conditions tight. When we look at the labour market in India, there is no sign of any tightening of the labour market as the post-pandemic unemployment rate (as per the CMIE) has remained at similar levels as in the past. The unemployment rate has averaged 7.6 percent over the past year. In fact, unemployment has inched up since January 2023 and rural wage growth has slowed down in the same period. This indicates a slack in the labour market and should concern the government if it heralds slowing down of economic growth. Where does that leave the Reserve Bank of India (RBI) whose monetary policy committee will be meeting on June 6 to discuss its next action?
Supply-side Factors
In its last monetary policy decision, the RBI chose to pause its repo rate hikes which the governor clarified was not a pivot. It is possible that in spite of the recent slowdown in the labour market, consumer prices will continue to rise because of cost-push factors. A comparison of CPI inflation with wholesale price index (WPI) inflation portrays an interesting picture. In the case of the former, we see a disinflation pattern with the inflation rate slipping below 5 percent in April 2023 (for the first time since November 2021). As for WPI, it is now in the deflationary territory with the April print coming at -0.92 percent, the lowest in 34 months. It is commonly believed that a movement in WPI shows up in CPI with a lag, once retailers pass on their costs to consumers. However, for a long spell of 18 months that ended last year, WPI inflation was in double digits but that did not show up as a surge in consumer prices. It is possible that producers absorbed the rise in costs by taking a hit in their margins. And now that WPI inflation is nose-diving, we may not see the expected pass-through to consumer prices as producers may be taking it as an opportunity to recoup the lost profits of the previous years. If producers act in this manner, CPI inflation may not decline as sharply as the drop in WPI inflation.
Secondly, the El Nino concern that the RBI governor recently flagged could upset the forecasts of a normal monsoon this year. With global oil prices cooling down, food prices have been the driver of inflation in recent times. The Rabi harvest has already taken a bit of a hit due to erratic weather and moving forward the Kharif crop will play a crucial role in determining the inflation rate. Thirdly, the so-called base effect that has partly contributed to the fall in the inflation rate will wear off as the year progresses and end by October 2023. A combination of these factors will continue to pose upside risks to inflation and may not allow the RBI to turn its rate hike pause into a pivot even if the economy needs some accommodation.
This is simply an outcome of the inflation targeting policy that does not allow the RBI to distinguish between demand pull and cost push inflation and necessitates a response to both. In future, a move to other frameworks like nominal output targeting could enable the RBI to turn accommodative when inflation is dominated by supply-side factors that are endemic in a developing market like India.
Rudra Sensarma is Professor of Economics, Indian Institute of Management Kozhikode. Twitter: @RudraSensarma. Views are personal, and do not represent the stand of this publication.
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