Taming inflationary expectations

Who’d have thought under the MPC, the first case of deviation of the inflation rate would undershoot the target?

Updated - July 24, 2017 12:31 am IST

Published - July 24, 2017 12:02 am IST

The official inflation rate dipped to 1.5% last month , the lowest in almost two decades. Inflation is a politically more sensitive challenge than joblessness for the simple reason that it affects everyone, whether you have a job or not.

India’s long-term record in managing inflation has been very impressive when compared with most developing countries. We have never had the bouts of hyperinflation experienced in many Latin American economies or seen even in countries such as Israel. The relatively high double-digit inflation experienced between 2010 to 2013 was an aberration, which had a political consequence. There have been very few instances of such persistent, multi-year, high inflationary episodes in our history. The credit for this goes to the vigilance of the political system and also to effective monetary management. Inflation is after all a monetary phenomenon — more money chasing fewer goods. So, controlling money supply is part of the strategy for controlling inflation.

Food prices as indicator

But inflation is also an indicator of whether there is an excess demand or supply of goods. For instance, with a bumper crop of fruits and vegetables, prices plunge, even though money supply might be unchanged. Indeed, the recent drop in the inflation rate has been caused by a steep fall in the prices of vegetables (-17%) and pulses (- 22%). Conversely, and rather ironically, unseasonal rains in the north have destroyed a large part of the tomato crop causing prices to skyrocket. Food prices, especially of perishables, are notoriously volatile. High onion prices, even if temporary, have caused the downfall of governments in past elections. Food prices are a big component in the determinant of the overall inflation rate based on the consumer price index basket. Keeping them low and stable involves policies such as public procurement and a minimum support price regime. Inflation control thus involves a combination of monetary management along with measures to increase supply of goods (in the medium term) as also anti-hoarding measures or the release of stocks from government warehouses.

Even though price stability is an important goal of government policy, it is now an exclusive mandate given to the Reserve Bank of India (RBI). Last year, in a landmark reform of monetary management, the government officially gave an inflation target to the RBI. Prior to this, the central bank had multiple objectives which included enhancing growth and reducing unemployment, although price stability was undoubtedly paramount. The new paradigm, called the “flexible inflation targeting” framework, aims for a numerical target given by the government. The main tool to achieve it is by setting the benchmark interest rate. This decision is now taken by the six-member monetary policy committee (MPC) , chaired by the Governor. The current inflation target is 4% plus or minus 2%. The MPC is deemed to have failed if for three consecutive quarters the inflation rate falls outside the band.

Low inflation pointer

Who would have imagined that in the new MPC regime, the first instance of deviation of the inflation rate would undershoot, not overshoot the target? Of course, technically, the MPC has not failed, for the June inflation rate of 1.5%, which is below 2%, may be transitory. However, there are strong indications and forecasts by many economists that point to low inflation in the coming months. Those numbers may be in the range of 2 to 4%.

How did we get to this low inflation scenario? Partly it must be because the money supply has been kept “dear”, or tight. Thus, the benchmark rate (called the repo rate, or the rate at which the RBI gives money to banks) at 6.25% may be too high. Interest rates are the “price” of money, so if they are too high, money becomes scarce. If it is lowered, then there will be more money in circulation, more loans given out. But low inflation is also because of a steep fall in prices of fruits, vegetables and pulses, none of which was caused by high interest rates. These steep falls are highly seasonal. We have also benefited from low and stable crude oil prices, which are a crucial determinant of transport and energy costs.

All eyes will now be on the MPC which meets again in less than two weeks. There is a strong feeling that high interest rates have deterred big industrial investments, or housing finance. High rates are crippling borrowers who try to come out of near-bankruptcy and are preventing a restructuring of stressed bank loans. India’s real interest rates, i.e. net of inflation, are quite high even compared to other developing countries. Much of the developed world has ultra-low rates, with some countries such as Sweden, Switzerland and Japan even having negative interest rates. India needs much lower rates for higher GDP growth.

But the job of the MPC won’t be easy. This is mainly because its task is to target future inflation, not the past. The future has some troubling portents. The short run impact of the Goods and Services Tax (GST) is bound to be inflationary. That’s because a bulk of India’s GDP is in services whose tax rate has moved from 15% to 18%. Besides, while sellers wait for their refund, i.e. input tax credit under the GST, their cost of capital locked up might go up. Many State governments have introduced additional levies to counter their apprehension of a loss of revenue under the GST. Besides the GST, there is the impact of the award of the Seventh Pay Commission to government employees. This effect will cascade to public sector organisations and State-level employees as well, and put pressure on prices. A third factor could be the loan waivers announced in some States which can cause fiscal stress. High deficit spending is not compatible with lower interest rates. A fourth factor is the uptick in commodity prices worldwide as metals and food prices are looking up.

The last, and probably the most important, factor weighing on the MPC’s mind would be inflation expectations. Household surveys conducted by the RBI indicate that people are expecting inflation to be close to 10% , not the 1.5% as is reported now. You may say that these expectations are irrational, but they do affect behaviour. In this season of salary increments, try giving someone a raise of 2%, as is common in the developed world. Workers will howl. Even their official dearness allowance is much higher. The real challenge is to slay this inflation expectations monster. In much of the western world, they are fighting disinflation if not outright deflation. But in India we are still struggling with inflationary conditions and expectations.

In English the verb for inflation is inflate. It refers to rising prices. But in most Indian languages, the equivalent word in usage is “ mehengaai ”, which refers to affordability and cost of living. Not all inflation is unwelcome. So if stock prices go up, that is good cheer. But “ mehengaai ” is hated by all. A low and stable inflation rate is a perquisite for sustained high economic growth. Mehengaai is antithetical to it. In the medium term, the growth impact of the GST, the improving ease of doing business — and hence increasing supply of goods — and a strong domestic currency, will all help keep inflation low. But the short run challenge is to temper inflationary expectations and keep them tethered.

Ajit Ranade is an economist

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