Subdued growth, not inflation, the real worry

A jump in government spending—funded by a rise in corporation taxes—could be helpful, but, in its absence, the economy must make do with liquidity and low interest rates.

Retail inflation in June, at 6.3% y-o-y, was more or less where it was in May—well above comfort levels. More worrying, though, is the sharp fall in sequential momentum in factory output; it may have been less severe than the one post the first wave, but that is of no consolation given the magnitude of that first fall. Indeed, the economy is barely recovering, and for this reason, the Reserve Bank of India (RBI) will need to hold back any retreat from its accommodative liquidity policies, perhaps till the end of 2021. As for raising policy rates, that is not likely now until mid-2022.

Pulling away from a policy—in which liquidity is plentiful and interest rates are moderate—before the recovery is firmly embedded could be harmful to the economy, especially since the government is not likely to spend beyond the planned levels. On the contrary, it could cut back on some expenditure to try and rein in the fisc at close to targeted levels.

Prices of food appear to be stabilising; adjusting for the base effect, food inflation has moderated in June. However, as pointed out by HSBC economist Pranjul Bhandari, the momentum remained elevated at 7.9% quarter-on-quarter (seasonally adjusted and annualised). There’s no cause for alarm, but the monsoon needs to get back its momentum—and the quantum and dispersion of rains in July is critical; else, the trajectory of food prices could change.

The not-so-good news is that core retail inflation remains high, at close to 6% y-o-y; not surprising at all, given the elevated prices of most commodities, especially crude oil. Sequentially, core inflation stayed virtually flat after a nasty spike last month, which is encouraging, and economists believe it could remain in the region of 5.5% for the rest of the year. Consequently, CPI inflation is expected to stay at around 6% levels in the near-term, but could head down to 5.5% levels or even lower by March 2022.

To be sure, there are several factors that will play their part in determining price trends over the next few months. To begin with, the moderation in global food prices should continue and prices of crude oil too need to plateau at these levels. At home, supply-side disruptions need to be fully addressed; this is important because the second half of the year could see a demand-pull-led rise in prices for goods and also for services. Companies that have so far not been able to pass on the higher cost of inputs may opt to do this once demand starts picking up.

All said and done, inflation is far less a worry right now than growth, which remains subdued. Most high frequency indicators, whether retail auto sales, PMI for goods and services, or loan growth, remain weak. Factory output contracted sharply in May—by nearly 11% month-on-month, after expanding for five months. May data might not be the best yardstick since it saw the peak of the second wave lockdowns across the country. But the severe contraction seen in both consumer durables and staples—production of durables fell to 28% below pre-pandemic levels—is a concern. A jump in government spending—funded by a rise in corporation taxes—could be helpful, but, in its absence, the economy must make do with liquidity and low interest rates.