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Demand does not seem to be driving inflation in India. RBI also states that growth is trailing below potential, indicating muted demand pressure on inflation. Central banks certainly cannot ignore inflation created by pick-up in demand. The dilemma on policy choice arises when supply shocks drive inflation. Overall, inflation may go up due to these shocks but their impact soon reverses if they are temporary. Hence, such inflationary episodes do not necessitate interest rate increases by the central bank. But this is not the case with inflation in India as some of the supply shocks have persisted stubbornly. This elevates inflationary expectations and raises the risk of percolation of supply shocks into generalized inflation. RBI, therefore, cannot overlook them even in today’s weak demand scenario.

For understanding inflation dynamics from a monetary policy perspective, it is useful to separate inflation into two components—noise and signal. “Noise" comprises elements of the inflation basket that tend to be highly volatile and whose impact on inflation is usually transitory and can be ignored by central banks. “Signal", in contrast, reflects demand-side pressure on prices and provides an indication of the future inflation trajectory.

Rising core inflation, treated as an inflation signal, warrants central bank action. The noise elements that are currently putting pressure on inflation include administered prices, food, global crude prices and a sharp depreciation of the rupee. The problem today is that not all of these are transitory in nature.

Take the case of administered fuels such as diesel where prices are set by the government. This category has seen very high inflation rates (over 20%) in the last few months. In a scenario where global crude prices have risen, the rupee has depreciated sharply and the government is confronted with the fiscal imperative to cut subsidies, the pressure on prices in this category will continue. Another example of noise that will put sustained upward pressure on inflation is electricity. Inflation in electricity has soared to 15% in the last one year compared with 3% a year back. Electricity prices had been suppressed for a long time but sharp increases have now become inevitable to pare the losses of distribution companies. This pressure, too, is likely to continue for the foreseeable future. Although aligning artificially suppressed prices of fuel and electricity to their market prices will be beneficial over the medium run, these prices will lead to inflationary pressures for some more time.

Food inflation is treated as “noise" as it is highly volatile and is supply-driven. But with food inflation rising to double digits in the last six-seven years, from sub-5% level in the preceding decade, it can hardly be treated as a one-time supply shock.

The recent history of inflation in India tells us that a part of the food inflation was not merely the result of supply shocks but also due to demand created by loose fiscal policy and the structural shift towards proteins. With the demand pressure that will arise from implementation of the national food security law, the continued structural shift towards proteins, and the practice of setting minimum support prices for foodgrains, food inflation is likely to remain high.

The pressure from food inflation (accounting for 46% of household consumption) also plays through the expectation channel. In other words, citizens, after experiencing high food inflation for the last few years, believe that variety of inflation is here to stay.

Even with gross domestic product growth at 4.4%, signals from core inflation are confusing: inflation in core WPI is low at 1.9% but core CPI is over 8%.

The issue is not one of choice between noise and signal for monetary policy decisions. The central bank has to look at both and consider the risks of transmission of noise into core inflation/signal and inflationary expectations, particularly if the noise is persistent. An assessment of whether the noise elements are likely to quickly reverse or persist is critical for monetary policy decisions.

Analysis suggests that the pick-up in some noise components of inflation that is being seen currently is unlikely to reverse soon. In such a situation, easy monetary policy can breed conditions for high generalized inflation by speeding up the transmission of persistent noise into inflation signals and further fan inflationary expectations.

And lastly, but equally importantly, RBI cannot play a lone hand in the fight against inflation. Reducing the fiscal deficit and improving food supplies through reforms in agriculture will be critical for achieving the objective of stable 4-5% inflation. Some improvement has been seen in the fiscal situation last year, which, if sustained, should help. RBI has taken a tough decision and its forward guidance suggests that it could continue to do so.

Dharmakirti Joshi is chief economist, Crisil. Comments are welcome at theirview@livemint.com

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