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Shyamal Banerjee/Mint
Shyamal Banerjee/Mint

Benign inflation: scope for monetary accommodation?

India's real interest rates had been in the negative territory for nearly 6 years given the double-digit retail inflation

The persistent problem of galloping inflation has been reined in the past six quarters. While part of the checks have been exogenous, led by the global disinflationary forces, domestic price pressures have also been well arrested given subdued demand and prudent food management by the government.

India’s real interest rates had been in the negative territory for nearly 6 years given the double-digit retail inflation. The inflationary pressures had largely risen from supply side bottlenecks, which made it difficult to keep pace with the above-trend gross domestic product (GDP) growth. Exacerbating the inflationary pressures had been the fiscal expansion focusing on populist measures such as higher minimum support prices (MSPs) and consumption boosting measures such as Mahatma Gandhi National Rural Employment Guarantee Act (MNREGA), without concomitant focus on productivity. Higher rural wages, rising agricultural cost of production, changing consumption pattern in favour of nutritional items all led to stubbornly high food inflation. Global super commodity cycle further weighed on inflation.

Against this background, the Reserve Bank of India’s (RBI’s) inflation targeting approach and the glided path of achieving consumer price index (CPI) based inflation near 4% in the medium term has been a key step in the right direction. Institutionalising RBI’s inflation focus, the government in a positive move has formulated a new monetary policy framework with a targeted range of 4% (plus or minus 2%). Since then, inflationary pressures have been well controlled given the RBI’s focus on inflation, coupled with a tight fiscal discipline with adequate focus on expenditure switching towards productive assets. Despite deficient and spatially uneven monsoon for the second consecutive year, food inflation has been leashed due to pre-emptive actions.

Another key driver of the benign inflation trajectory has been the plunging global commodity prices. From an average retail inflation of 10% between financial year 2008-09 (FY09) and FY14, inflation has slipped to nearly 5.5% in the past 18 months.

This trend is expected to continue over the next year as well given the entrenched disinflationary pressures arising from muted domestic demand and subdued global commodity prices. Prudent food management policies and marginal increase in MSPs (due to subdued global food prices) should help keep food inflation well anchored. Additionally, muted real rural wage growth is further expected to keep a lid on price pressures. The importance of this factor in determining trends in food inflation is noted in a working paper by RBI (Analytics of Food Inflation in India, October 2014), which shows that increasing real rural wages have played the most dominant role in the determination of overall food inflation in India in the long run.

Even as the upside risks of inflation remains limited, this should not be prematurely considered as a victory on inflation. Inflationary expectations have been inching up for three consecutive quarters. Any further meaningful easing in inflation going forward is unlikely to happen.

While the core inflation in the first nine months of 2015 has averaged around 4.1%, excluding fuel components (refined core inflation), which may be considered as a better gauge of underlying demand side price pressures, has averaged at about 5%. The refined core inflation has remained sticky in the range of 4.7-5.1%, as against 3.8-4.5% range witnessed in core inflation. The stickiness in the refined core inflation clearly suggests the persistence of supply constraints in the services sector, thereby signalling limited scope for further decline in core inflation.

Also, with food prices subject to vagaries of changing climate, the trend in food inflation is likely to converge towards the headline inflation. While the government has undertaken various short-term measures to curb spikes in food inflation, it is of utmost importance to design a long-term inflation management framework to reduce the supply-demand mismatch in the agricultural sector. It is, therefore, necessary to focus on increasing productivity through enhanced investments and technology coupled with improvement in supply logistics.

Given the persistence of disinflationary forces, it is the opportune time to de-bottleneck the supply side issues and move towards a non-inflationary sustainable growth trajectory. Not to forget, there exists a risk of pickup in consumption and inflation due to the implementation of the 7th Pay Commission next year. A delay of nearly two-and-a-half years in implementation of the 6th Pay Commission and the consequent payout of accumulated arrears resulted in a massive jump in demand, adding to inflationary pressures. However, these risks are not expected to materialise to the extent seen in the previous Commission given the expectation of a timely implementation of the 7th Pay Commission.

Average FY17 inflation is estimated at 5.5%, compared with 5% in FY16, with an upside risk of about 50 basis points in the CPI inflation due to the implementation of the 7th Pay Commission early next year. (One basis point is one-hundredth of a percentage point.) However, RBI has noted that the direct impact of this on inflation may be looked through in decision making. It has clearly frontloaded the 50-basis point rate cut, thereby limiting any room for further easing this year. However, with growth expected to remain subdued and inflationary pressures to be benign, a 25-50-basis point easing can be expected next year.

Upasna Bhardwaj is economist, Kotak Mahindra Bank.

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