After navigating successfully through the worst global crisis since the 1930s, Indian policymakers now face a new challenge: rapidly rising inflation. After posting year-on-year declines as recently as August 2009, headline inflation, reflected in the Wholesale Price Index (WPI), almost touched the double-digit mark in February. Consumers have been feeling the pinch of rising prices for longer: Consumer prices for industrial workers, for instance, have been hovering in the double digits since late 2008. Though WPI inflation may be reaching its peak, it will pass the 10% mark next month and is likely to remain high throughout this year. This poses immediate challenges for the Reserve Bank of India (RBI).
Illustration: Jayachandran / Mint
The increase in inflation has been to a large extent driven by food prices, but price pressures have increasingly become broad-based. In the last couple of months, more than half of the increase in WPI can be accounted for by price hikes outside of food and fuel. Core inflation—which excludes food and fuel prices—is currently running at 5% (year-on-year) and has increased by nearly 5 percentage points in three months. This pickup in core inflation is unsurprising, given the strength of the economic rebound. Industrial production growth averaged a staggering 17% year-on-year in the last couple of months. Other short-term activity indicators also point to a continuation of the robust growth in overall economic activity.
More interesting trends appear when we look at sequential measures of inflation, such as seasonally adjusted month-on-month. First, while the year-on-year rate of inflation turned negative in June and only moved back to positive territory in September, month-on-month rates started to pick up much earlier. In fact, headline inflation started to accelerate as the real economy turned around at the beginning of the 2009-10 fiscal year. By September, when several observers were still talking of WPI deflation, sequential measures of WPI inflation were showing that headline inflation was closer to 7.5%, clearly on its way to the double-digit levels expected by the end of 2009-10.
The risk of high and accelerating inflation is that inflation expectations become unmoored. In the face of price pressures over the last year, the man on the street as well as professional forecasters have unsurprisingly been reassessing their views of inflation trends. Surveys conducted by RBI show that inflation expectations have drifted upward. Similarly, expected inflation measured by Consensus Forecasts (based on a sample of professional forecasters) also climbed: Inflation is now expected to average 6.6% in 2010-11, a full percentage point higher than just three months ago. Even without formal wage indexation or large-scale collective bargaining arrangements, such increases in expected inflation are bound to translate into higher wage demands and higher prices.
RBI has started to take steps to control inflation as it recognized that the sharp rise in inflation and the concomitant increase in expected inflation called for more than just vigilance. Since January, RBI has increased reserve requirements and more recently, in a move that surprised market participants, it hiked interest rates by 0.25 percentage point. This occurred ahead of the regular policy meeting scheduled for 20 April and, in the view of market participants, constitutes the beginning of a tightening cycle.
The interest rate hike is also an important signal that RBI remains committed to price stability. Many see the move as necessary to keep inflation expectations well anchored since the Indian economy is farther advanced in the economic cycle than most other major economies. Nevertheless, several indicators suggest that monetary policy is still accommodative (for example, policy interest rates are negative in real terms), but given the strong rebound in growth and rising inflation, a gradual tightening of monetary policy will be needed in the period ahead.
While higher benchmark interest rates could increase borrowing costs for some, RBI has appropriately sent a powerful signal that tighter monetary policy will help keep inflationary pressures at bay, which will in turn help stabilize longer-term interest rates. As the saying goes “no pain, no gain”—some would say you have to bear the pain of somewhat lower growth temporarily to control inflation. After all, the presumed pain inflicted by higher short-term interest rates pales in comparison with the potentially destabilizing effect of high inflation. By staying away from risking higher inflation, RBI has wisely chosen not to take this gamble.
Roberto Guimaraes-Filho is a senior economist working on India in the International Monetary Fund’s Asia and Pacific department. Kalpana Kochhar is the deputy director in the same department. Comment at firstname.lastname@example.org