Inflation and the rate cut conundrum

Inflation should eventually retreat as India now has a negative output gap
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First Published: Mon, Dec 17 2012. 03 24 PM IST
A file photo of RBI governor D. Subbarao. Photo: Hemant Mishra/Mint
A file photo of RBI governor D. Subbarao. Photo: Hemant Mishra/Mint
Updated: Mon, Dec 17 2012. 04 09 PM IST
Is inflation receding? A lot depends on the answer to this question, since the price situation is one of the key reasons why the Reserve Bank of India (RBI) has been unable to cut interest rates to support a weak economy. It will announce its next monetary policy move on Tuesday.
The Indian central bank has been unable to keep wholesale price inflation within its targeted range for more than 30 months in a row, a situation that could eventually undermine public confidence in monetary policy. Rising inflation expectations are one indication that people expect high inflation to continue despite what policymakers may say. So RBI needs to win a decisive battle against inflation if it has to maintain its credibility; premature rate cuts could be damaging in the long run.
But how can we know if such a victory is round the corner? The Indian situation is complicated by the fact that there are several inflation measures that need to be watched. Here is a quick look at how they have done since January 2011.
1. Wholesale price inflation has gradually eased, though it continues to be above the official comfort level of the central bank. It has slowed from 9.47% in January 2011 to 7.24% in November.
2. Core inflation, which does not include volatile food and energy prices, has fallen far more steeply over the same period—from 6.5% to 4.5%. This is a number which is closely watched by RBI, and is likely to be used to bolster the case for an interest rate cut whenever the central bank thinks it is ready, which in all probability will be in January 2013.
3. Consumer price inflation continues to be close to double digits; in fact, the latest data shows that it accelerated in November. Data on the new nationwide Consumer Price Index is still inadequate, so it is difficult to draw firm conclusions. But there is enough anecdotal evidence to suggest that consumer prices are still out of control, especially food prices.
4. The GDP deflator is the widest measure of inflation, and can be calculated from the quarterly national income data. It fell during the last quarter of fiscal 2012, but has since inched up. Inflation measured by the GDP deflator was 9% in the first quarter of fiscal 2012, but came down to 7.9% in the second quarter of the current fiscal. This is the second quarter in a row when it has increased.
So, there are different patterns depending on which inflation number, one is looking at. Taken together, there is not enough proof that inflation has ceased to be a problem though the worst seems to be over. The biggest problem continues to be consumer price inflation, because inflation expectations of households—and, hence, their wage expectations—are formed by the prices they see in the market every day.
Inflation should eventually retreat as India now has a negative output gap; in other words, economic growth has been below potential. But the latter itself has been falling thanks to the collapse in investment activity in recent quarters. So the size of the output gap is unclear. The various estimates of the rate at which the Indian economy can grow without setting off an inflationary fire ranges from 7.5% to as low as 6%. The persistence of inflation despite the recent economic slowdown suggests that the potential growth rate is perhaps getting closer to the lower end of the range.
That is the real cause for long-term worry—and the solution is to recharge the investment cycle through policy reform rather than interest rate reductions alone.
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First Published: Mon, Dec 17 2012. 03 24 PM IST
More Topics: inflation | economy | RBI | WPI | CPI |
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