The inflation chameleon could keep RBI on its toes
PremiumRBI might not be able to ignore a cost-push and inequality-driven rise in price levels within India
Inflation in India is high and the Reserve Bank of India (RBI) can’t ignore it any longer. Consumer prices have risen over an annualized pace of 4% for 21 consecutive months and breached the 6% upper tolerance limit over a dozen times. Wholesale prices are accelerating even faster. And rural inflation is outpacing urban inflation, possibly due to villages being more impacted by logistical disruptions and stronger demand in rural areas.
The dominant narrative is as follows: High inflation is being driven by temporary factors which will fizzle out soon. But before one driver fizzles out, a new one comes along, keeping the inflation rate elevated.
Let us elaborate on various drivers. Lockdown-led disruptions were a key driver of inflation in mid-2020. Pent-up demand for goods took over at the end of 2020 as restrictions eased, then disruptions caused by a second wave of covid showed up in mid-2021 and continue today, exacerbated by high global commodity prices.
With inflation shifting amid changing conditions, much like a chameleon, it’s important to stay vigilant on any new developments. We will track three specific drivers over the next few months:
One, cost-push inflation: Traditionally we find that firms pass on about 60% of input price increases to consumers. This time around, they have passed on about half the rise in global commodity prices. Small firms have been more hesitant, perhaps worried that demand will weaken further. But as vaccination spreads, smaller firms may feel more confident about passing on price increases to consumers.
Two, inequality-led inflation: A key structural shift over the last year has been the rise in inequality—both at the firm and individual level. Large firms have been more profitable, and the employees of large firms have earned more than those of small firms.
We find that rising inequality does not just hurt growth over time, but also distorts prices. At the firm level, there is evidence that the pricing power of large firms has risen over the past year. At the individual level, higher demand for services like healthcare and travel can distort prices. The rich tend to consume more services than the poor, and as they get vaccinated, a disproportionate rise in demand could stoke services inflation. Unlike goods, services are largely non-tradeables, and price rises cannot be imported away easily.
Three, monsoon-led inflation: This is another area that needs monitoring, although we do not want to ring alarm bells. Sowing has been weak so far this season (5% below normal as of 30 July). But reservoir levels are much better placed (49% versus the 41% long-term average), and that offers hope. We have found that reservoir levels do a much better job of forecasting food production and inflation because they not only account for contemporaneous rains, but also the carry-over moisture from the previous season.
All said, we expect consumer price inflation to average an above-target 5.4% year-on-year in 2021-22, with food inflation around 4% and core inflation close to 6%. What does this mean in terms of RBI action? RBI has been proactive throughout the pandemic, helping ensure that large companies avoided defaults and bringing down borrowing costs across the yield curve. But there are some good reasons why RBI should embark on a gradual exit from its ultra-loose policy. Monetary policy has its limits in driving up growth. It is a counter-cyclical tool that can help close the output gap, but not drive potential growth. Research shows it’s important to act tough in the early years of inflation-targeting in order to influence subsequent expectations and make the inflation-targeting regime a success. Looking around us, while we don’t forecast that central banks like the US Fed or European Central Bank will hike rates for two years, some others, including those of Brazil, Mexico, Russia and parts of Central and Eastern Europe, have already started tightening. An exit from loose monetary policy needs to be a function of one’s own domestic realities.
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How is RBI likely to proceed? Starting in the fourth quarter of 2021, we expect RBI to start draining surplus liquidity, raising its reverse repo rate (at 3.35% now) and changing its stance to neutral. We expect repo rate hikes to follow later: a half percentage point rise in the second half of 2022, followed by 50 basis points more in 2023, taking the rate to 5%.
RBI will also have to think carefully about the ‘impossible trinity’, a concept that says a country can’t maintain a managed exchange rate, flexible monetary policy and open capital borders at the same time. Last year, RBI bought bonds, dollars and injected a lot of domestic liquidity, and didn’t worry about the potential impact on inflation. But if RBI wants to start normalizing policy, it will have to rethink its strategy on buying bonds and dollars. Current core liquidity —the sum of liquidity in the banking system and the funds that the government is sitting on—is quite elevated, close to ₹10 trillion. RBI has several tools at its disposal to drain surplus liquidity and deal with conflicting objectives, but it will need to prioritize and plan carefully.
In its 6 August meeting, however, RBI may want to sit tight amid fears of a third wave of covid, but is likely to sound more concerned about inflation than before.
Pranjul Bhandari is chief India economist at HSBC.
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