In recent times, high inflation has been occupying the centre stage among key concerns for policymakers, economists and market participants. Far from happy times of negative inflation of -0.39% in June 2009, today Indian economy faces the challenge of near double-digit inflation at 9.68% in March 2011. We attempt to examine the reasons for the high inflationary expectations and damaging impact a stubbornly high inflation can have.
In sync with other global central banks, in response to the global financial crisis in 2008, the Reserve Bank of India (RBI) had cut interest rates aggressively and injected huge amounts of liquidity to revive the economic growth momentum. World governments took upon themselves the task of keeping the economic engine running by recording historically high budget deficits to pump prime sagging growth rates. Between October 2008 and April 2009, RBI reduced key policy rates in a combination of repo and reverse repo rates by a massive 575 basis points, which brought down reverse repo rate to a record low of 3.25%. Besides, to finance the high government borrowing programme, RBI bought back government bonds from the open market. All this served its purpose and the Indian economy quickly regained the traction to record among the highest gross domestic product (GDP) growth rates in recent history and achieved the enviable status of the second highest growing major economy in the world, just behind China.
Given the severity of the financial crisis and the massive destruction it caused to the world economy, reversing these emergency measures was always going to be an academic’s nightmare. The balancing act between ensuring that there is no relapse into a double dip recession and avoiding the inevitable high inflation that was to follow due to high global commodity prices and domestic supply constraints was never before so delicate. To its full credit, RBI was among the first major central bank to start the rate tightening cycle. However, inflation today threatens to slow our economic growth prospects. One would recall that in the initial phase, inflation was primarily driven by high food prices which rose at almost 20% for the last two years. Even as this component has slowed in recent months, manufacturing sector inflation has picked up significantly and now stands at close to 7.50%. A robust growth prospect for corporate earnings suggests continued pricing power with the manufacturing sector implying persistent high inflation in the near term, more so as the impact of recent hikes in diesel, kerosene and liquefied petroleum gas prices will reflect in inflation numbers to be reported in the coming weeks. Even without that current inflation at around 9.5% is a full 2% higher than RBI policy rate of 7.50%, keeping real interest rates in negative zone and continuing to ignite further inflationary prospects.
Future inflation trajectory
It would, however, be inappropriate to turn extremely pessimistic on this front. The series of rate hikes by RBI in the last one year should start moderating inflation in the coming months. We have witnessed a moderating trend in both the Index of Industrial production (IIP) and GDP growth as per recently reported data.
There are three key variables which will impact the future inflation trajectory. Firstly, a properly distributed normal monsoon will help keep the food prices moderate. Secondly, very high crude oil prices in global markets due to growing world demand, unrest in some oil supplying zones of North Africa and West Asia and a weak US dollar has reflected in high domestic fuel prices. Recent increase in margins by world exchanges on oil futures contract and a release of strategic reserves by International Energy Agency has led to a steep correction in oil prices in last few weeks. That provides hope that our government may not need to increase domestic fuel prices again in a hurry. Finally, removing supply side constraints will have to be taken up to counter the ghost of inflation in the long term. India is a young and vibrant economy with main growth factors being infrastructure development, lifestyle change and demographics. The increasing demand from growing population has to be met with higher supplies.
The ill effects of inflation
Even if inflation slows to a more modest 5% down the line, three years of 10% inflation will still make everything 33% more expensive. While large companies and the wealthy section of society will still be able to offset the harsh impact through higher margins in the first leg, it is the middle and lower-middle class which will have to suffer the most. More so, as in the current cycle, the largest contribution to inflation has come from food and other primary article prices which constitute a relatively larger part of lower-income groups. The backbone of the current optimism on long-term Indian economic growth prospect is firstly a favourable demography comprising large young middle class set for a lifestyle change in a increasing disposable income scenario and secondly building of infrastructure to support that growing demand. High inflation will directly reduce the disposable incomes and curtail this demand.
A government constantly struggling to contain fiscal deficit will also increasingly find it difficult to allocate additional resources to infrastructure development. A classic example could be oil companies which are not left with enough profits to support adequate research and exploration budget. In a sustained inflationary environment, companies’ profits would also suffer as the pricing power will dilute due to reduced aggregate demand. This, as would be easy to understand, will weaken the long-term sustainable growth rate.
The world is currently witness to the situation where Greece, a member of the European Union, is on the brink of default on its debt obligations and no less than US is under threat of its AAA credit rating being lowered. While India is poised to become an economic super power in future, the speed would certainly be slowed down if inflation does not moderate to sustainable levels.
Mahendra Jajoo is executive director and chief investment officer, fixed income, Pramerica Asset Managers Ltd.