Inflation | Slaying the enemy gets complicated

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If the yield curve is a public good, inflation is the public enemy. That is the moniker ascribed to inflation in a recent article in the Economist. This month, slaying the public enemy became the uppermost concern for Indian policymakers as the Reserve Bank of India (RBI) and the government joined the battle.

In its surprise, off-cycle action on May 4, the RBI hiked the policy rate and proportion of cash reserves to be held by banks; a series of supply actions from the government including a wheat export ban reacted to food inflation and fuel duty reduction last week aimed to check retail energy prices. Food and energy prices are the most potent component due to high secondary spill overs and entrenchment risks, and the squeeze upon cost-of-living. Taming inflation, however, has become a lot less straightforward. The trade-off with output is grim as the challenge arrives in early stages of its revival.

The pulls and pressures are many and intensifying. One, the US Federal Reserve’s commitment to price stability has firmed. US Fed Chairman Jerome Powell stated the Fed won’t hesitate to keep hiking rates until inflation is tamed. Many assess the RBI’s surprise action was compelled by the Fed’s decisive meeting later that day.

Two, along with China’s slowdown for entirely different reasons, slowing world growth is becoming surer. Three, food and energy prices’ show little moderation signs, although industrial commodities’ prices are.

Four, the unbridled producer price growth — 15 percent in April, the fastest in nearly three decades — is pressuring pass-through to consumer prices that accelerated to 7.79 percent last month (March, 6.95 percent); food prices grew 8.4 percent. The build-ups are a threat to underlying inflation, which is already strong and persistent. Five, exchange rate depreciation pressures have increased from a strengthening US dollar, capital account strains - foreign investment flows in Feb-March were net negative and portfolio outflows sustained to now, widening interest rate differentials and trade deficit.

Output growth is ambivalent on the other hand. Industrial production weakened to an average 1.6 percent in January-March against 2.1 percent the previous quarter; corresponding growth in manufacturing that is closely tied to export growth was even weaker at 0.9 percent versus 1.4 percent; and infrastructure/construction was the only segment to accelerate an average 7.5 percent after 3.9 percent before in indication that government capex is the only lead.

The financial side matches the real-inflation-adjusted bank credit growth which slowed to 2.4 percent in the last quarter (2.7 percent in October-December quarter), with marginal pick-up last month (2.5 percent); bank deposits extended as private loans has been stagnant this year (72 percent). Last month, the manufacturing PMI picked up only a tad. Positive impulses come from services with full commencement (the PMI increased 4.3 points above March), which raises likelihood of increased employment in turn. Export growth has been strong too; however, this is at risk from a slowing world demand and trade growth.

There’s extreme all-round uncertainty about the evolution of above settings. Monetary action has just begun in India and abroad. Within the monetary policy framework, demand strength matters utmost. In June, the RBI will provide updated projections of inflation and growth. Analysts’ revisions place average inflation in FY23 between 6.3-6.9 percent. Speculation is now centred upon the quantum and timing of further hikes, shift to neutral, and tightening therefrom. The MPC minutes indicate realignment to pre-pandemic policy rate, 5.15 percent, may be imminent; it is an open question if the remainder will be one-shot or spaced out to August, especially with last week’s fiscal counter-measures.

The next leg of adjustment, to positive real rate, is critical because of the balance vis-à-vis output. In the MPC minutes, RBI Deputy Governor Michael Patra said these responses can be calibrated after reaching neutral accommodation. In the April post-policy interaction, he’d stated it was premature to work out a real rate of interest due to insufficient data points, and return to positive was a dynamic situation. MPC member Jayanth Varma stated the real policy rate is gauged by the path of inflation 3-4 quarters ahead; in a following interview to CNBC-TV18, he specified this isn’t precisely known and probably should be around 0.5-1 percent.

There isn’t a clear answer on the neutral rate, which maximises output with inflation stable around target. In the prevailing environment, forecast inflation is itself mired in exceptional uncertainty. The potential output, for which the RBI does not give any estimate, has likely been damaged from years of investment slowdown, pandemic, and other shocks.

Doubts arise if the underlying inflation persistence is a representation — core inflation is above percent for nearly two years, more than 6 percent for a year. Formalisation has been rapid and steep — both pandemic and input cost pressures have led to exit of many small firms — but the magnitude, and if that will sustain profit margins, isn’t known.

Contrary indications are the stark divergence in two-wheeler sales against those of cars; inflation blows to real disposable incomes – the dominance of these forces ought to restrain inflation. Much, however, is uncertain, including firms’ pricing behaviour in exceptional growth of producer prices, currency depreciation, and rising interest costs.

Therefore, the risk of endangering output in achieving price stability, the uppermost goal, is non-trivial. However, with inflation predicted above 6 percent in FY23, and core inflation crossing 7 percent last month, inflation psychology could dangerously settle in this range, dis-anchoring inflation expectations. The critical question is where could growth settle.

Renu Kohli is a New Delhi-based macroeconomist. Views are personal, and do not represent the stand of this publication.