Opinion | The great inflation conundrum that the Indian economy faces
4 min read . Updated: 09 Jun 2020, 09:15 PM ISTIt’s intriguing that inflation is sticky despite a recession but its explanation lies in figuring out the nature of our covid shock
Indian monetary policy makers delivered a surprise in May. It had nothing to do with their decision on interest rates. The Reserve Bank of India (RBI) did not release forecasts for either economic growth or inflation as part of its latest monetary policy announcement. The monetary policy committee (MPC), in its meetings every two months, usually provides estimates of inflation over the next four quarters. The Monetary Policy Report, published twice a year in April and October, provides inflation forecasts for the next eight quarters. Central bank communication to our financial markets pivots around these inflation forecasts.
These are not trivial matters. Monetary policy works with a lag of around three quarters, so what RBI does today is based on where it expects inflation to be three or four quarters down the line. Interest rate policy cannot be based on current levels of inflation. In fact, a central bank with a formal inflation target uses its price-level forecast as an intermediate target of monetary policy. So, not releasing such a forecast strikes at the heart of the new monetary policy framework.
The explanation offered by RBI governor Shaktikanta Das was that unprecedented uncertainty combined with the fluid state of affairs in an environment battling the covid-19 pandemic made forecasting very fragile. There is some validity to this explanation. Forecasting in uncertain times is a tricky job, as model parameters become unstable. However, it would still have been possible to provide an inflation forecast with a wide range of possibilities around a central estimate in fan charts.
There are more reasons for ambiguity on the inflation front. The problems of collecting price data during the lockdown also mean that the official inflation numbers for April and May are based on limited data points. Government statisticians usually collect monthly price data through field visits to select urban and rural markets. These were suspended in March because of the country’s lockdown, and limited data was collected over the phone. Even the official inflation numbers need to be handled with care.
Members of the MPC also seem to disagree on whether covid-19 is a disinflationary shock or not. This can be gleaned from the MPC minutes that were released last week, though one cannot help wonder whether the availability of forecasts by individual MPC members, perhaps through dot plots, would have helped clear some of the fog in these times.
There are three other pieces of evidence in the context of the inflation outlook. First, the inflation expectations of households have increased in May. Inflation expectations for three months ahead are up by 190 basis points, while those for a year ahead are up 120 basis points. The most recent spike in inflation expectations come after a long decline since the introduction of inflation-targeting by the Indian central bank. The level of household inflation expectations is often an inadequate indicator since these tend to be very sensitive to food prices, but the direction of change in these expectations tells us a lot.
Second, the inflation expectations of businesses polled by the Indian Institute of Management, Ahmedabad, present a mixed picture. Inflation expectations for one year ahead touched their highest level since the survey began in May 2017. They went up sharply from 3.85% in February to 4.57% in March. Companies were expecting cost pressures to build up. The data for April is slightly better. Business inflation expectations are still above the level before the covid-19 shock, but 20 basis points lower than the March reading. Informal conversations with businessmen suggest that many of them expect their wage bills to go up once the economy gets back on track.
Third, a panel of professional forecasters polled by the Indian central bank predicted in May that the economy would shrink by 1.5% in fiscal year 2020-21—this is a full 7 percentage points lower than what the forecasters had expected in the previous round that was conducted in March.
The sharp downward revision in the growth forecast is not unusual. Most agencies have sharply reduced growth estimates for the Indian economy after it was hit by the covid-19 shock. It is worth noting that the polled professional forecasters are not expecting inflation to collapse in tandem with growth. Their forecasts of headline as well as core inflation have been brought down only by 20 basis points each since March. In other words, they expect inflation to be stable despite a massive change in the growth momentum.
The Indian inflation situation is very confusing right now. Inflation measurement is tricky, expectations are volatile, and the forecasts fragile. It is not clear why inflation is sticky despite the first recession in more than four decades. Inflation had collapsed even during the far less brutal downturn after the effects of the North Atlantic financial crisis hit Indian shores in 2008. The answer to that lies in the big analytical question: Is India facing a supply shock or a demand shock right now?
Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics
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