National Council of Applied Economic Research
Opinion: Poonam Gupta
Overall the best way to keep prices competitive and inflation low in any economy is by ensuring efficient production structures resulting in low cost of production continuous innovation leveraging of scale economies better integration within domestic and with international markets and implementation of sustainable fiscal and monetary policies.
Inflation is making a comeback globally. A number of advanced countries are experiencing inflation rates that are higher than corresponding rates during the last several decades. As a result the monetary policy easing cycle seems to be mostly over. Last week the Reserve Bank of India (RBI) kept key interest rates unchanged for the eighth time in a row. Most central banks in emerging markets have paused lowering of their policy rates and some have started raising them. For example in the last couple of months Brazil Chile Mexico and Peru have raised their policy rates.
An important policy-relevant question in such a situation is whether inflation has become too high or too entrenched in India to warrant a change of course of monetary policy. Some commentators have highlighted the persistently high inflation rate and called for caution and vigilance in setting future monetary policy.
However the large swings in data due to varying intensity of Covid- 19 over time make it more difficult to interpret inflation numbers than is the case in normal times. To gain better understanding I have calculated the average consumer price index (CPI) inflation core inflation and food inflation during the 18 months following the onset of the Covid pandemic (March 2020-August 2021). I then compare these average rates with those prevailing prior to Covid and ask whether there are specific pockets of high inflation and whether the Indian inflation correlates with global counterparts.
This analysis yields three conclusions. First inflation in India has averaged 6% in the last 18 months. Seen this way it falls within the inflation target band of 2-6% (RBI’s Monetary Policy Committee or MPC notched it down to 5.3% last week). Of the headline inflation numbers the core inflation which excludes volatile food and fuel prices has averaged less than 6% a year. Conversely food inflation has been a tad higher.
Second and more surprisingly the average rate of inflation during 18- month Covid period has been similar to that during the two years preceding it. As such there is no structural break in inflation. The pre- and post-Covid inflation numbers are similar not just for headline or core inflation but also for most of the components of the inflation basket. The Covid period represents continuity rather than discontinuity.
Inflationary Decoupling
Third till date data do not give enough basis to conclude that higher inflation has become entrenched. Household inflation expectations in India remain notoriously sticky and decoupled from actual inflation rendering them an unreliable signal of future inflation. At the same time professional forecasters continue to exhibit expectation of moderate inflation.
So can India afford to be complacent? Given that disruptions in global supply chains labour scarcity-induced wage increases and generous stimulus packages have led to rising rates of inflation in some countries could India too become a victim of similar inflation in the forthcoming months? Could developed country inflation have a spillover effect on inflation in India?
To answer this question I conduct a simple exercise to assess how well inflation in India correlates with global inflation. The exercise reveals that during the last 18 months of Covid-19 inflation in this country does not correlate significantly with global inflation inflation in the US or that in emerging market economies. The answer remains unchanged if we focus on the pre-Covid period.
These findings mean the current inflation in India remains range-bound is not entrenched and is unlikely to be impacted significantly by higher inflation elsewhere. Consequently India need not change its current stance on monetary policy.
Another implication is that the flexibility provided by the inflation-targeting framework has been on full display both during Covid as well as during the economic slowdown in the pre-pandemic years. The framework has acquired sufficient credibility that inflation as well as inflationary expectations have remained anchored allowing monetary policy to respond to growth concerns by remaining appropriately accommodative.
The assessment presented here may change in the coming months especially if the global supply chain issues start impacting India directly. The impending tapering of easy monetary policy in the US also has the potential to elevate inflation through a depreciation of the rupee.
Efficient and Economic
A typical response to the unwinding of the US Fed’s ultra-loose monetary policy for emerging markets such as India would be a matching increase in the policy rates. Should such an unwinding come to pass it will serve India well to keep its ammunition dry for now and use it when such a time comes.
Overall the best way to keep prices competitive and inflation low in any economy is by ensuring efficient production structures resulting in low cost of production continuous innovation leveraging of scale economies better integration within domestic and with international markets and implementation of sustainable fiscal and monetary policies. Given India’s current income levels and its growth aspirations in a macro sustainable way all of these are worthy avenues to pursue via continued structural reforms.
(The writer is the Director General at the National Council of Applied Economic Research NCAER. The views expressed are personal.)